Tactical Asset Allocation Based on the Yield Curve

I spend a lot of time talking about asset allocation on the blog. I’ve presented quant systems that focus on price-based tactical asset allocation, cross-market momentum strategies, and mean reversion strategies (just to name a few). Some older posts are:

A Quantitative Approach To Tactical Asset Allocation

Asset Class Rotation

Mean Reversion After Really Bad Months

Asset Class Returns Based on Fed Policy

Inflation and Asset Class Returns

Sector Rotation with Hedging

I was originally going to put this out as a white paper, but seeing that I have about 5 of those on the back burner (and this seems to be a pretty well-known property), I thought a simple blog post would do.

Below we examine the effects of the yield curve on our group of asset classes.

(Data sources: Global Financial Data)

US Stocks – S&P 500

Foreign Stocks – MSCI EAFE

Bonds – 30 Year US Govt

Commodities – GSCI

REITs – NAREIT

Spot Gold

Buy and Hold is an equally-weighted, monthly rebalanced allocation to the above 6 asset classes.

First, we examine how the 10 year US Govt Bond – 90 Day Tbill rate affects the return of various asset classes. We selected three modes, but by no means are these optimized or optimal. The table below presents the percentage of time spent in each mode, as well as the annualized returns for the annualized returns for the asset classes.

One could devise a simple timing system based on these properties.

When the yield curve is <0%, long commodities and gold.

When the yield curve is 0 – 2%, long US and foreign stocks.

When the yield curve is >2%, long bonds and REITs.

This simple system would have beaten buy and hold by over 4% a year over the time period with more volatility (mostly upside) and a similar drawdown. Equity curve below:

Comments

[Rhunzzz:]

What do you mean when the yield curve is <0%?

Are you referring to the gradient of the curve? The spread between 2 and 30-year interest rates?

Nov 16 04:03 AM

[JohnnyJunk:]

I assume he means the spread. But, I echo your question.

Nov 16 09:36 AM

[Cecil:]

He means the spread in absolute terms.


On Nov 16 04:03 AM Rhunzzz wrote:

> What do you mean when the yield curve is <0%?
>
> Are you referring to the gradient of the curve? The spread between
> 2 and 30-year interest rates?

Nov 16 10:15 AM

[oldman:]

yield curve is currently >3 referring to 90 day T-Bill to 10 year Treasury. Favor bonds and Reits? Bonds, maturity?

Nov 16 11:37 AM

[Stone Fox C...:]

really think the 0-2% range could be expanded to include whether the yield is expanding or contracting. I've noticed that stocks do much better when contracting. Its probably counter intuitive but basically the economy is doing better then the fed can raise rates/lower yield curve. Finally though the Fed chokes off growth as the yield curve gets to 0 and stocks suffer.

Would assume a big different in bonds as well with rising or falling rates.

Nov 16 12:16 PM

[User 35426:]

Shouldn't the 0-2% scenario be long commodities and US stocks,
and the 2+% scenario be REITs and foreign stocks

if we're looking to allocate to the two best-performing asset classes?

Nov 16 12:17 PM

[Stone Fox C...:]

it also appears that the dynamic of the last 2 cycles is different then historical norms. Maybe the fed is more reactive now and behind the curve. The more they lowered rates the last 2 recessions the lower the market went.

Nov 16 12:30 PM

[WorldBeta:]

Updated charts here:

www.mebanefaber.com/20.../

Nov 16 01:46 PM

[Stone Fox C...:]

apparently the Yield Curve relationship broke down at the end of the 2000s. Until then the YC method was beating the Momentum method. For whatever reason, in the 2000s stocks began reacting differently to rate changes.


On Nov 16 01:46 PM WorldBeta wrote:

> Updated charts here:
>
> www.mebanefaber.com/20.../

Nov 16 04:45 PM

[starvin sar...:]

Hey Mebane, I have read you for several years, thanks for this. Instead of 30 year would you recommend STRIPS instead? It would seem a better vehicle in this environment. I have been buying EDV on dips, for long term charting use WHOSX. You would be surprised how well gold and STRIPS work 50/50 through the years, great correlation with that mix. Rebalancing at a 15% move in either and it looks really good. But I do see the value of just buying the best performing asset. Still I would be interested in a mix of the best and worst performing in a long term portfolio, especially if you average into the worst buying low through the cycle, i.e. a contrarian value style. It seems that the long bond and gold often are at the extremes making them a good pair if you can stand the ride. Just offering ideas here guys...unless of course hyperinflation comes our way who then could stand long bonds! SS

Nov 16 07:51 PM

[E.D. Hart:]

There is also something to be said for being long gold and commodities when real interest rates are negative (as they are now) and being long stocks and bonds when real interest rates are high, positive, and about to fall (think 1983).

From 1971 to 1983 real interest rates rose (not in a straight line) and peaked late 1983. From there on, it was about a 17 year bull markest for equities, and bonds too if you bought at the peak.

The analgous situation today is that we are in low and falling real interest rates similar to 1974. For the next 7 years real rates were negative--it paid to borrow and invest in commodity type assets that outpaced inflation.

Weve been thrown into a brutal recession from high oil, and speculative leverage in real estate, and rates will be kept low for some time. Contrary to media outlet reports, real inflation is positive (not governement bogus cpi data), and therefore real interest rates are negative, and falling as inflation picks up.

The question should be: how to invest in a negative real interest rate environment? The answer is clear--gold, silver, commodities until real rates turn positive.

Nov 16 08:10 PM