Top Recession Indicator Makes a Lousy Sell Signal for Stocks

(Bloomberg) -- Federal Reserve officials and Wall Street are ramping up their warnings about an inversion of the Treasury curve. When long-term yields dip below shorter-term counterparts, it’s usually been a sign that a recession is nigh.

Equity investors, however, might want to be more worried about what happens when the gap between short- and long-term borrowing costs moves in the other direction.

The spreads between two- and 10-year as well as five- and 30-year Treasury yields sunk to their lowest levels in more than a decade this week. Confidence in the continuation of the Fed’s tightening cycle is swelling, creating a bear-flattening dynamic for the majority of 2018 wherein short-term yields have risen faster than their peers with longer maturities.

Investors ought to get bearish on U.S. stocks not when the curve is bear flattening or the 2s10s spread turns negative, but rather when the opposite trend is in effect, writes Mayank Seksaria, head of macro strategy and research at Macro Risk Advisors. That’s bull steepening, in which short-term yields fall faster than long-term yields as the market prices in monetary stimulus to compensate for a downturn in growth.

"Conventional wisdom focuses on the flattening toward zero or inversion in the yield curve as a precursor to the end of the cycle," he wrote in a note to clients on Wednesday. "While this is nominally true -- the curve does historically flatten prior to recessions -- the utility of this signal to risk management is unclear at best and questionable at worst."

In fact, the two-year forward returns for the S&P 500 Index after the curve inverts have actually been positive, on average, over the past 40 years. The strategist attributes this phenomenon to the substantial lags between when the spread turns negative and the onset of a recession, a "late-cycle period" for equities. Meanwhile, an investor who shorted the S&P 500 Index when the curve is in bull-steepening stretches and was long at all other times vastly outperformed an investor who bought and held the benchmark U.S. equity gauge throughout the entire period.

“The yield curve inversion signal is overhyped as a timing tool,”’ Seksaria concluded.

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