Courtesy of Doug Short.
Note from dshort: Last night I received an email from a reader asking about the relationship between the 2-10 year Treasury spread and the stock market.
The 2-10 spread observation most commonly mentioned is the occurrence of a negative spread as a leading indicator of recessions. The first chart below shows the spread from the earliest 2-year Treasury data, which starts in June 1976. As we see, the inversion of the spread (i.e., the 2-year yield is higher than the 10-year) has an excellent record as a leading indicator of recessions, although the amount of lead has been considerable — a year or more. Also, let’s remember that the yield inversion is a completely objective metric, whereas the identification of an official recession is a rear-view call, a year or more after the fact, by the NBER.
Since markets often top before recessions, we can also see a correlation between 2-10 spread inversions and market peaks. In this series, both metrics (the spread and the market price) are both objective.
But now, in the era of the Fed’s extended ZIRP (zero interest rate policy), the reliability of the 2-10 spread as a leading indicator of either recessions or market behavior is questionable. In the current environment of Fed interest-rate policy, a recession without a preceding inversion is not just a possibility, but perhaps what we should expect. For more on this topic, see the recent guest commentary by Lance Roberts: Yield Curves and the Fed Model.
