With the yield curve hitting its flattest level of the expansion last week, many are wondering what impact that will have on the stock market.

Data Sources for all tables herein: NBER, FRED, Bloomberg. Using monthly data.

The yield curve is a leading indicator of the economy, but the stock market is one as well. So to provide advance warning for stocks, the yield curve must be a longer leading indicator.

Looking back at history, that does seem to be the case. The yield curve has inverted before 6 out of the last 9 recessionary stock market peaks, with an average lead time of 8 months.

In the last economic cycle, the yield curve would invert 21 months before the stock market peak in October 2007. That’s a long time to wait, exposing just one of the problems in using the yield curve to time your stock market exposure.

Another issue is that the stock market is not the economy. Stocks can go down without a recession or a yield curve inversion, as we saw most recently in 2011.

Thus far we’ve focused only on an inversion of the curve as it relates to stock market peaks.

What does the yield curve level itself tell us, if anything, about general stock market performance?

The chart below illustrates S&P 500 returns at various yield curve levels. There does not appear to be a linear relationship here between the yield curve and the concurrent return for stocks.

In the lowest decile for the yield curve (-3.07% to -0.27%), stocks have generated an annualized return of 6.9%, a higher return than in the second decile (4.5%). At the current yield curve level of 0.66%, stocks have annualized at 18.9%.

But since the yield curve is a longer leading indicator than stocks, what we really want to focus on is future returns.

Does the stock market perform worse after flatter or inverted levels for the yield curve?

There does seem to be some evidence of that, with the weakest forward stock market returns occurring in deciles 9 and 10 (yield curve range of -3.07% to 0.09%).

The odds of a positive return are lower as well.

We’re still a ways off from entering the bottom two declines today, but this is something to keep in mind. As the yield curve flattens towards inversion, the odds suggest a more difficult period for stocks awaits. It is important to remember, though, that this is by no means a prerequisite; stocks can decline sharply irrespective of the curve.