The Inverted Yield Curve, Be Prepared
Summary
- The U.S. Treasury Yield Curve Just Inverted for The First Time Since 2007.
- Debate on The Implications Ranges from Meaningless to Extreme Danger.
- Misinterpretations of this signal are discussed.
- A Quantitive approach to Tactical Asset Allocation strategy is applied and analyzed.
On Friday, March 22nd, 2019 the United States Treasury yield curve inverted for the first time since we exited the last recession. If you are not an active or long-time investor, you might not know what the yield curve is. The market has a history with yield curve inversions. Knowing if you should do anything in response can mean the difference between being ok or losing 40%+.
There are a few articles out on Seeking Alpha and other financial analysis websites that use the average time from yield curve inversion to recession. These strategies don't consider all the possible ways the market can react. After experiencing a yield curve inversion the market has reacted quickly before and using an average can be a mistake.
First we discuss what the yield curve is and what inversion is. Then we go over the historical market impact from a yield curve inversion and discuss other conclusions. Finally, we discuss asset allocation strategy and show a model applying a 200-dma to improve performance .
“The four most expensive words in the English language are ‘this time it’s different.’” – Sir John Templeton
What is the Yield Curve?
The yield curve is a graph of the current yields of United States Treasury securities. It starts with a 1-month security and ends with a 30-year security. The three types of securities that make up the yield curve are Treasury bills (or T-Bills), Treasury Bonds (T-Bonds) and Treasury Notes (T-Notes).
Created by author using data from Treasury.gov
Created by author using data from Treasury.gov
The table above displays the latest data from the U.S. Treasury on the yield curve. We've highlighted where the inversion happened. We’ve also included a graph of the yield curve the day it inverted.
What causes it to invert?
Bond yields go down as prices come up. There are two actions that contribute to a yield curve inversion. An increase in the selling of the 3-month treasury and an increase in the buying the 10-year bond. As prices decrease for the 3-month treasury, the yield increases. Inversely, prices increase for the 10-year bond and the yield decreases. Once the yield for a 3-month treasury is greater than the yield of a 10-year bond, the yield curve has inverted.
Why wouldn’t the yield on a long-term investment always be higher?
It is very strange that the yield on a short-term security is higher than a long term one. This is telling us that the demand for a safe, long-term bond has spiked while the demand for a short-term bond has dropped. This means that investors are looking for safer places to store their money. Away from the stock market and other risky investments and into the 10-year treasury.
This is also caused by the fixed income market speculating that the Federal Reserve could cut rates. By buying long to medium term bonds and not short term bonds investors seek to gain the most from a rate cut as it will affect the price of a 10-yr or 30-yr more than a 3-month security. This is due to their duration.
Why does inversion matter? Where did it come from?
In 1987 a finance Ph.D. dissertation written by Campbell Harvey explored the use of the fixed income market as a leading indicator for future recessions. At the time many in the world of finance research were skeptical. Yet time has been on Dr. Harvey’s side. Since his paper in the Journal of Financial Economics, the yield curve has been a great leading indicator of economic trouble. It predicted the recessions of 1990, 2001 and 2007. After inversion in 1989, 2000 and 2006. Inversion was also followed by stock market crashes.
A Different Perspective: Historical Market Impact of an Inverted Yield Curve
Every author seems to be creating a table like this one here.
Created by author using data from U.S. Treasury website and Finance.yahoo.com
The month after inversion column is calculated using monthly averages of the 3-month and 10-year yields. This approach is the same as the approach taken by Estrella and Adrian used to support Harvey’s signal theory (Source Paper). The date of bear market column is calculated using a -20% change from the market top. It should be noted that in 1990 that date of the bear market was also the market bottom.
Using these averages, authors say that investors should not panic and to hold on for at least the next 7 or 8 months. This interpretation is dangerous and potentially very wrong. It only took 8 months for a bear market to form during the dot-com bubble. The market top in 1980 was only 1.9 months after the yield curve inverted. Using an average is logical when it comes to return. When it comes to estimating risk from a technical signal, the range should be used and interpreted. Investors should start converting now and over the next two months into a defensive position. A portfolio with more bond exposure and less risky stock allocations.
There’s a well-written article on the yield curve making a solid case for why this time may be different by Macro Ops. The article title is “Yield Curve Inversion: Why This Time Is Different”. The author presents two cases for why this time is different. The first makes a valid point on the effect of Dodd-Frank legislation. It increased the holding requirements banks have to meet. They now have to more hold High-Quality Liquid Assets (HQLA’s) due to the increased Liquidity Coverage Requirements (or LCR’s). Research into the Swiss LCR and HQLA suggests that this HQLA premium is a move in the 3 to 4 basis points range (source). The yield curve inverted by 5 basis points on two days last week.
Created by author using data from U.S. Treasury website
This should not be interpreted as a full dismissal of the author's point. The impact that the LCR has on HQLA yields and prices is not simple. Taking the Swiss researcher’s premium and applying it to the current situation in the United States would be a mistake. The two are not apples to apples but nor are they apples to oranges. This comparison gives us a range to work with when estimating the impact. The impact is very difficult to estimate so this is our best benchmark for the time being.
Their second argument is the changing policy at the fed with rate changes. If the Federal Reserve slows interest rate hikes or starts cutting interest rates or even implements QE early into a recession, it will have an impact. It also won’t stop the inevitable from coming. Their policy changes will also have a diminished impact due to their current balance sheet and already historically low interest rates. Keep in mind, going into the 2008 recession the federal reserve stopped increasing the rate at around 5%, hitting 5.25% before slashing. We’re currently at 2.4%.
Asset Allocation Strategy
Deciding which market sectors to invest in to avoid the pain of a recession is not as easy as many would elude to.
Created by author using finance.yahoo.com
Looking at the various SPDR market sector ETFs, the best performing of the last recession were Consumer Staples ($XLP) and Energy ($XLE). This isn't suprising but materials performing well is ($XLB). Materials performed well due to the bull market rally towards the end of the cycle in 2007. Removed from this graph are Real estate and Financials ETFS. This is because they were extreme outliers due to the cause of the market collapse.
Created by author using finance.yahoo.com
To analyze the 2001 bubble, we’ve removed technology and added back in financials. In the dot-com bubble consumer staples, normally a safe place to invest in a recession were hit hard. This was due to the change of moving sales online by these companies. Thus affecting their stock price on the way up and down as the dot com mania drove prices. This market cycle, the winners were Materials ($XLB), Financials ($XLF), consumer discretionary ($XLY) and Health Care ($XLV).
This implies that Materials may be worth looking into as they perform well after the yield curve inverts and into the market crash. If they don’t perform well leading into the crash, they don’t offer much in the way of downside protection. Consumer staples traditionally perform well and is a sector that should continue to offer safety. Utilities are believed to be a safe sector. However, a precursory look doesn’t lead to this notation. This sector deserves future exploration before accepting or disproving this notion.
Created by author using finance.yahoo.com
Investment grade corporate bonds were a good investment with a 5.4% dividend over the time period of 9/1/2007 to 8/1/2008. The dividends continued as the price dropped and then recovered during the market crash and recession. This would be an excellent choice to increase your holdings and sleep better at night as we enter an uncertain economic future.
A model for a Quantitative approach to Tactical Asset Allocation: using A 200-dma to improve returns and reduce risk
I’ve written before about Meb Faber’s investing strategy here. To summarize, it shows that using long term simple daily moving averages (sma or dma) such as the 10-month or 200-day moving average as an entry or exit point when the asset price crosses over improves returns and reduces your risk.
I know that not all investors have the time, patience or energy to stay as active as their approach requires. So I added a second approach to try and improve returns and reduce risk without the need for being as active. My proposed strategy is simple. After the yield curve inverts, sell the first time the 200-dma is crossed. Do not buy again until after a 20% drop in the market has occurred. Then look to rebuy after the 200-dma is broken by the asset increasing in price. The asset in this scenario is the S&P 500 ($SPY).
Created by author using data from finance.yahoo.com
For the financial crisis, both approaches lead to a significant amount of success.
Created by author using data from finance.yahoo.com
Switching is the full active investing approach and Just Exit is our simplified approach mentioned above.
Created by author using data from finance.yahoo.com
Covering the dot com bubble, our simplified approach doesn’t compare to the active approach.
Created by author using data from finance.yahoo.com
While our simplified approach labeled Just Exit does improve our returns, it doesn’t compare. The positive return experienced by the daily active investor using the simple moving average is much larger.
In Conclusion
The market may not crash for a while. Our next recession may not come for a while. But the yield curve as a predictive tool has worked in the past and should have significance this time as well. Make sure to consider the whole range of history with the yield curve. Do not blindly use the average time it takes. Consider investing in a safer sector such as consumer staples. Also consider increasing your bond position. Consider taking an active approach. Using an active strategy can increase your returns and reduce your risk. This is especially improtant when market volatile is on the horizon. These approaches should help you sleep better at night while doom and gloom are on the market’s mind.
This article was written by
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.