An inverted yield curve does not an immediate stock-market inferno make. And Tony Dwyer, chief U.S. markets strategist for Canaccord Genuity, is urging investors to view a yield curve inversion as an opportunity rather than a death knell.
“An inversion of the yield curve does predict recession, but historically it is a better buy signal than pointing to a time to get sustainably defensive,” Dwyer said in a note to clients Monday.
Read: The yield curve inverted — here are 5 things investors need to know
An inversion occurs when the yield on long-term debt drop below its shorter-term peers, potentially signifying a lack of confidence in the economic outlook. It has also become a crucial early warning signal for economic woes, particularly in the wake of research from the San Francisco Federal Reserve that every U.S. recession in the past 60 years was preceded by an inverted yield curve.
On Friday, the three-month TMUBMUSD03M, -0.29% and the 10-year yields TMUBMUSD10Y, -1.78% — considered the most reliable recession barometer — inverted, spooking the stock market with all major indexes having their worst session since Jan. 3.
The spread between the two-year TMUBMUSD02Y, -7.75% and 10-year yields, another closely followed gauge, is also narrowing although it has yet to invert.
But were it to do so, it may be premature to panic, judging by Dwyer’s chart.
“Even if the YC (yield curve) inverts tomorrow, over the past seven economic cycles, the median SPX gain from the initial inversion to the cycle peak is 21%, with a recession a median 19 months after the initial inversion,” said Dwyer.
The strategist also stressed that other recession identifiers, including the Fed’s Senior Loan Officer Survey, household debt service and financial obligation ratios, and consumer delinquency rates, have yet to set off alarms.
As such, investors should wait for further signs of trouble in the credit market before turning defensive on stocks.
“The history of our favored credit metrics and what follows the inversion of the YC still suggests any weakness should prove limited and temporary,” said the noted bull.
Still, Jeff deGraaf, founder and chairman of Renaissance Macro Research, urged investors to proceed with caution.
“This is the 17th inversion signal (with a 3‐month reset) since 1962, and 9 of those produced negative 6‐month forward returns and 7 positive returns. Those are better odds of weakness than the average random 6‐month return,” he said in a report.
DeGraaf also believes an inversion is likely a red flag that something could go wrong and while it may take a while for things to unravel, history suggests the situation requires “respect.”
Or as Ted Bauman, a senior research analyst at Banyan Hill Publishing, puts it, “For forecasters, inverting yield curves have about the same significance as voodoo cursed totems for followers of that religion. That’s because they have preceded the last seven official U.S. recessions. They are therefore not to be taken lightly.”
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