The difference between the yield on 10-year and two-year U.S. Treasury bonds has dropped below 0.2% and is now at its lowest level since March 2020. Unfortunately, a flattening or negative yield curve can be a very negative indicator for the economy.
The good news for investors is that there have historically been plenty of investment opportunities even after yield curves have inverted.
Related Link: Recession Indicator: What An Inverted Yield Curve Means For Investors
Stay Calm: First off, just because economic hardship may be coming, it doesn't mean investors should be immediately dumping stocks as soon as an inversion takes place.
According to the San Francisco Fed, each of the 10 U.S. recessions that have occurred since 1955 came between about six months and 24 months after an inversion in the yield curve of two-year and 10-year Treasury yields. The yield curve last inverted in August 2019, about six months before the COVID-19 recession began in February 2020.
In other words, the stock market has historically peaked well after previous yield curve inversions, suggesting there may still be some upside to the SPDR S&P 500 ETF Trust (NYSE:SPY) if the curve inverts.
Bank stocks have historically performed poorly during periods of inverted yield curves. Banks typically profit by borrowing money in the short-term and lending it in the long-term. Therefore, an inverted yield curve pressures bank margins and profitability. The good news for bank stock investors, according to Bank of America analyst Savita Subramanian, is that investors don't need to be afraid of financial stocks if the yield curve inverts.
"While Bank earnings growth was 80% correlated with the 10Y/2Y spread from 1992 to March 2000, that correlation has dropped to just 17% following the Tech Bubble, and our Banks team has highlighted that the short end of the curve has become more important for Banks vs. in the 90s," Subramanian said this week.
How To Play It: In fact, Bank of America remains overweight on the financial sector and recommends high-quality stocks such as BlackRock, Inc. (NYSE:BLK), Charles Schwab Corporation (NYSE:SCHW) and First Republic Bank (NYSE:FRC).
The utility sector has historically been the top-performing market sector during the six months following yield curve inversions, suggesting the Utilities Select Sector SPDR Fund (NYSE:XLU) could be a bullish bet. Consumer staples stocks have also historically performed well when the yield curve is inverted, making the Consumer Staples Select Sector SPDR Fund (NYSE:XLP) a viable option.
Benzinga's Take: The most important thing for investors to remember if the yield curve inverts in the near future is not to panic. The S&P 500 has historically not peaked until over a year after a yield curve inversion, and it has averaged roughly 22% upside between the time of the inversion and the subsequent peak.
