What Do Top Gun and Yield Curves Have In Common?

Let’s talk about recessions!

All bull markets die! It’s a fact of life that eventually this epic run for stocks will come to an end and the economy will go into a recession.  By the time you read this you will have no doubt have heard that the yield curve has inverted, and this indicator has correctly indicated the last 7 recessions. 

What does an inverted yield curve really mean?

Every time I hear the term I think of the famous scene in Top Gun where Maverick discusses his foreign relations with the Russian MiG pilot.

via GIPHY

Charlie: Well, if you were directly above him, how could you see him?

Maverick: Because I was inverted.

Iceman: [coughs whilst saying] Bullshit.

Goose: No, he was, man, it was a really great move.

Charlie: You were in a 4G inverted dive with a Mig 28?

Maverick: Yes, ma’am.

Every time I hear Inverted Yield Curve, I think of 4G dives with Russian fighter planes.  But an Inverted Yield Curve isn’t a fancy flying maneuver it happens when the amount you get paid for owning a longer-term bond is less than the amount you get paid for owning a shorter-term bond.  In this case the 2-year treasury is inverted compared to the 10-year treasury. When the 2/10 yield curve has inverted it has successfully indicated the last 5 recessions.  But this inversion is not a good indication of when the recession is going to occur.  As my friend Ryan Detrick at LPL shows in this chart

As you can see from the chart this is not good for telling us when the recession will start.  It also is not good at telling us the severity of the recession.  What I tell all clients is to keep things in perspective and not panic.  Data shows the U.S. economy is on solid footing, and corporate debt spreads have remain contained in this latest bout of volatility. Financial conditions are still historically loose, yet there are few signs of excess in the financial system. U.S. stocks have also been resilient against yield curve inversions in the past: Historically, the S&P 500 Index has rallied an average of 22% from the first inversion to the eventual economic peak. Recessions are not the end of the world.  They are part of normal markets and if you stick to your plan you will reach your goals.  I am not a great pilot, so I won’t be doing 4G inversions with Russian MiGs and I don’t suggest you do them either.  Stay the course, know your plan and don’t overact to miscellaneous market events.