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An inverted yield curve happens when short-term interest rates become higher than long-term rates. For this article I will use the 10-year Treasury note for the long-term rate and the Fed Funds rate for the short-term.

The yield curve recently inverted, and market pundits are frantically forecasting the next recession. Why is this getting so much financial media attention and causing alarm among the investment cognoscenti?

One reason is that a curve inversion is an unnatural state for an economy. Why would an investor buy a 10-year bond when she could get a higher interest rate with a 30-day T-Bill? It makes no sense from a practical standpoint. Is the short-term rate too high, or is the long-term rate too low? I will address this later.

Curve inversions may be unnatural. But they happen, and it's happening now. Later in this article I'll offer some explanations for this upside-down interest rate environment, but first let's go through the inversions that have happened in the past. By doing so, we can gain some insight into what an inversion means to investors in stocks and bonds.

The big picture

The first chart comes from JP Morgan Asset Management. It shows the slope of the yield curve and the recessions that followed. This chart shows that when the curve inverts, a recession is very likely to follow several months later. I don't know of any economists who dispute this assertion; history is history and not theory.

There is a significant lag between the first inversion date and the onset of the recession. The average lag time is 14 months, which means that there is no need to panic. There will be sufficient time to change your asset allocation before the next recession comes to town.

Chart 1. The history of inversions and recessions

It's the stock market that worries me

Now that we've established that yield-curve inversions are a warning sign for oncoming recessions, and that the average lead time is 14 months, what can we do with this information? Nothing valuable if all we want to know is when the next recession is likely to arrive. I'm far more interested in finding out when the stock market is likely to top out and begin to roll over into bear territory.

To do this, let's begin with a look at each inversion from the last 50 years so we can pick up some clues about what may be coming next. After that I will show the numbers related to the link between inversions and market tops.

Chart 2. The bursting of the housing bubble and the Global Financial Crisis