In recent months, U.S. stock-market investors have been paying close attention to the yield curve, fretting that signs of flattening could presage a recession. However, the implications of the curve could have implications that stretch beyond Wall Street.
According to Charles Schwab, the curve also has a history of signaling peaks in international stocks, an issue that could be particularly important to investors today, given that concerns over emerging markets are seen as one of the sharpest headwinds facing stocks.
The yield curve refers to the spread between long- and short-dated maturities, such as the 10-year Treasury note TMUBMUSD10Y, -0.28% and the two-year note TMUBMUSD02Y, +0.61% Typically, the curve slopes upward, with investors demanding a premium to compensate for risks that can develop over time. A flatter curve, however, suggests more caution about the near-term outlook.
An inverted curve, in which short-dated yields rise above longer-dated yields, is a warning sign. Inversions of the Treasury yield curve have preceded the past seven recessions while throwing out two false positives with an inversion in late 1966 and a very flat curve in late 1998, according to the Federal Reserve Bank of Cleveland.
Currently, the yield curve is near its flattest level since 2007, with the 10-year yield trading around 23 basis points, or 0.23 percentage point, above the 2-year yield.
“Over the nearly 50 year period, the inversions came about one year before each global recession, but more significantly, came close to the cyclical peak in international stocks,” wrote Jeffrey Kleintop, chief global investment strategist at Charles Schwab. “While there can be no guarantees it will always do just as well, the successful track record over the diverse political and economic environments over the past 50 years provides good reason to watch it closely.”
The curve’s predictive ability, Kleintop wrote, is aided by the U.S. being the world’s largest economy, meaning it is a major source of demand for global companies. “In addition, the U.S. government bond market is the largest and most liquid in the world, which may mean it better reflects global conditions and is less susceptible to domestic influences than other countries’ bond markets.”
International stocks may have already seen their peak for the cycle, as they have struggled lately, with the U.S. easily outperforming overseas markets thus far this year. The Dow Jones Industrial Average DJIA, -0.09% is up 5% in 2018, with the S&P 500 SPX, +0.24% advancing 7.8% and the Nasdaq Composite Index COMP, +0.18% up nearly 15%.
To compare, the Vanguard FTSE All-World ex-US ETF VEU, +0.15% — and exchange-traded fund that includes every country’s market except the U.S.’s — is down 7.4% this year. The Vanguard FTSE Emerging Markets ETF VWO, -1.24% has shed nearly 13% in 2018, and it recently dropped into bear-market territory, defined as a 20% decline from a peak.
“We may still be some time from an inversion in the U.S. yield curve, suggesting international markets may still have some upside,” Kleintop wrote. “However, an important message from the U.S. bond market, if the U.S. yield curve does invert, is that international stocks may be close to a peak even without inversion in the yield curves of other countries.”
Currently, the yield curve in the U.S. is flatter than the European equivalent.