This Is the Inversion Stock Investors Should Sweat

U.S. stock investors who are anxiously watching the yield curve are worried about the wrong inversion.  

Investors have been howling about interest rates since Monday, when part of the U.S. Treasury yield curve inverted for the first time since 2007. The five-year Treasury yield dipped below that of the three year by a razor-thin 0.01 percentage points. Yawn.

Granted, that’s not supposed to happen. The yields for longer-term bonds should be higher than those for shorter-term ones to compensate bond investors for parting with their money for a longer period. When investors accept a lower yield for longer-term bonds, it implies that they expect interest rates to decline. And declining rates have often been accompanied by recessions and bear markets.

But the fuss is overdone, at least so far. The “inversion” is so minuscule that it’s imperceptible on an actual yield curve. It’s also limited to a small part of the curve. As others have already pointed out, an inversion between the two-year and 10-year Treasury yields would be more noteworthy. 

Instead, investors should keep an eye on a different inversion: the difference between the earnings yield on stocks and the yield on cash. When the earnings yield has dipped below the cash yield in the past, stocks were in for a rough ride.

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