Summary
- It is generally considered a bad sign if the 10y-3mo or the 10y-2y differences in yields fall.
- This is particularly true if the differences in yields fall below zero (a yield curve inversion).
- However, the crash of 1987 happened as the yield curve was steepening, not flattening or inverting.
A crash without an inversion
When talk of a market crash intensifies, many people look for clues from the US Federal debt market to assess the probability of a crash happening soon. There is a widespread belief that the main clues come from Treasury yield differences, or the yields paid by US Federal debt instruments with different maturities.
It is a bad sign if the 10y-3mo or the 10y-2y differences in yields fall below zero (a yield curve inversion). However, as you can see on the figure below, the 1987 stock market crash happened around the time the 10y-3mo and 10y-2y yields peaked.
We show both the 10y-3mo and the 10y-2y differences in yields because some market experts have more confidence in the 10y-3mo signals, whereas others prefer those given by the 10y-2y differences. The reality seems to be that both the 10y-3mo and the 10y-2y differences in yields provide the same overall signals.
But the inversion preceded the recession
Having said that, the 1987 crash was followed by another smaller crash, related to the 1990 recession. This recession was indeed preceded by a yield curve inversion.
So, one could say that the yield curve inversion worked yet again, as it has done repeatedly, as a leading indicator of a recession.
Conclusion
The yield curve inversion phenomenon is a very good predictor of economic recessions, arguably one of the best leading indicators available to investors. And market crashes usually happen around recessions. But a market crash may happen without an economic recession.
In fact, the crash of 1987 happened as the yield curve was steepening, which is essentially the opposite of flattening – and arguably a bullish signal.
