Recession On The Way? David Alan Carter
The bond market is whispering something to investors. That something is definitely important. Or maybe not. It’s a little hard to tell in a market with more moving parts than the tax code.
One thing is certain: this week saw a yield curve inversion.
The bond market is whispering something to investors. That something is definitely important. Or maybe not. It’s a little hard to tell in a market with more moving parts than the tax code.
One thing is certain: this week saw a yield curve inversion.
Yield Curve Inversion
The U.S. Treasury yield curve refers to the line you see when you plot the interest rates paid on all U.S. Treasuries - bills, notes, and bonds – and then connect the dots.
For reference, the U.S. Treasury Department issues Treasury bills for terms of less than a year, notes for terms of 2, 3, 5, and 10 years, and bonds in terms of 20 and 30 years. Collectively, they are often referred to as Treasuries.
In “normal” times the yield curve should rise, curving up and to the right. In return for downside protection, investors in short-term Treasuries are willing to accept a paltry amount in interest (yield) because their money isn’t tied up for long. They plot low and to the left on the graph. Investors in long-term Treasuries demand a higher interest rate because their money is tied up longer. They plot high and to the right. And during these “normal” times, risky assets like stocks are free to party like spring breakers. Because, well, everything’s normal.
But let that curve begin to flatten, or a section of that line (gasp!) invert, and there is a noticeable shift in sentiment: the partying begins to slow and more and more stocks are like deer caught in headlights. Something’s wrong.
That something is the dreaded “R” word.
This past Monday, 5-year yields moved higher than the 30-year yields, something that hasn’t happened since 2006 (two years later, we were in the throes of the Great Recession). The next day, the more closely watched 2 and 10-year yields inverted briefly as investors sold off the longer-dated Treasuries anticipating more aggressive interest rate hikes from the Fed. A 2-and-10 inversion last happened in 2019 (and sure enough, the U.S. entered a recession one year later - albeit one caused by a pandemic).
So, What’s Going To Happen?
For sure, we don’t know. While it’s true that every recession has been proceeded by an inverted yield curve, not every inverted yield curve has resulted in a recession. There’s a joke on Wall Street that the yield curve has predicted 10 of the last 5 recessions.
And then there’s the timing issue. If indeed a recession is in the cards, the lag time from inversion to recession is typically 12 to 24 months. That’s a sufficient chunk of time that you do not want to be out of the market. Indeed, stocks typically do well immediately after an inversion, with the S&P 500 averaging an 11% return in the 12 months post inversion.
We may have seen the beginning of that, with stocks (hopefully) bottoming on March 14, and then coming out of the gate with a full head of steam. As of this writing, the S&P 500 is up around 8%, and the Nasdaq has pulled itself out of a bear market, just since mid March.
Of course that could change on a dime. As I write these words, the Dow just closed down 550 points. Why? Well there is, after all, a war raging. Prices spiking (especially food and energy). A Fed signaling a more aggressive posture. Growing signs of a housing bubble.
And Elon Musk, whose company is building Optimus, a general purpose robotic humanoid, is now threatening to build a new social media platform.
On that last point, with any luck, this robot army will spend their days chatting up one another on this new parallel Twitter, and leave the rest of us the hell alone.
The U.S. Treasury yield curve refers to the line you see when you plot the interest rates paid on all U.S. Treasuries - bills, notes, and bonds – and then connect the dots.
For reference, the U.S. Treasury Department issues Treasury bills for terms of less than a year, notes for terms of 2, 3, 5, and 10 years, and bonds in terms of 20 and 30 years. Collectively, they are often referred to as Treasuries.
In “normal” times the yield curve should rise, curving up and to the right. In return for downside protection, investors in short-term Treasuries are willing to accept a paltry amount in interest (yield) because their money isn’t tied up for long. They plot low and to the left on the graph. Investors in long-term Treasuries demand a higher interest rate because their money is tied up longer. They plot high and to the right. And during these “normal” times, risky assets like stocks are free to party like spring breakers. Because, well, everything’s normal.
But let that curve begin to flatten, or a section of that line (gasp!) invert, and there is a noticeable shift in sentiment: the partying begins to slow and more and more stocks are like deer caught in headlights. Something’s wrong.
That something is the dreaded “R” word.
This past Monday, 5-year yields moved higher than the 30-year yields, something that hasn’t happened since 2006 (two years later, we were in the throes of the Great Recession). The next day, the more closely watched 2 and 10-year yields inverted briefly as investors sold off the longer-dated Treasuries anticipating more aggressive interest rate hikes from the Fed. A 2-and-10 inversion last happened in 2019 (and sure enough, the U.S. entered a recession one year later - albeit one caused by a pandemic).
So, What’s Going To Happen?
For sure, we don’t know. While it’s true that every recession has been proceeded by an inverted yield curve, not every inverted yield curve has resulted in a recession. There’s a joke on Wall Street that the yield curve has predicted 10 of the last 5 recessions.
And then there’s the timing issue. If indeed a recession is in the cards, the lag time from inversion to recession is typically 12 to 24 months. That’s a sufficient chunk of time that you do not want to be out of the market. Indeed, stocks typically do well immediately after an inversion, with the S&P 500 averaging an 11% return in the 12 months post inversion.
We may have seen the beginning of that, with stocks (hopefully) bottoming on March 14, and then coming out of the gate with a full head of steam. As of this writing, the S&P 500 is up around 8%, and the Nasdaq has pulled itself out of a bear market, just since mid March.
Of course that could change on a dime. As I write these words, the Dow just closed down 550 points. Why? Well there is, after all, a war raging. Prices spiking (especially food and energy). A Fed signaling a more aggressive posture. Growing signs of a housing bubble.
And Elon Musk, whose company is building Optimus, a general purpose robotic humanoid, is now threatening to build a new social media platform.
On that last point, with any luck, this robot army will spend their days chatting up one another on this new parallel Twitter, and leave the rest of us the hell alone.
As noted before, long term, the strategies will get the trends right. Short term, there may be a miss or two as the market juggles conflicting signals. So keep allocations of strategies reasonable within your portfolio, and remember that protection** remains paramount.
Best always,
David
________
** What does protection look like? At the extreme, it’s cash. As I mentioned last month, it’s OK to hold some cash. Cash is, in fact, a position. It means you’re prepared to act when circumstances better align with your risk tolerance.
Protection can also mean an overweight position in a model built for protection (i.e., Bond Bulls, Lean Muscle, The 12% Solution). It can mean putting multiple strategies to work in a portfolio, especially when those models tend toward an inverse relationship with each other, or focus on different asset classes or market sectors. Think Bond Bulls and American Muscle. Or Global Trader and The 12% Solution.
Because each strategy uses a slightly different mechanism to identify market risks, and because each can employ different funds representing different market sectors (although there is obviously some overlap), there is beneficial diversification at work when using multiple strategies within a portfolio – helping to reduce volatility and max drawdown.
Finally, protection can mean keeping an eye on the provisional picks during the month. These can provide a heads-up on potential trends -- and breakdowns of existing trends. Look for asset class shifts (a switch from an equity fund to a safe harbor asset like cash or bonds, or the contrary). See if such a shift holds up for a few days. Not every such move is a trading opportunity or justifies a rebalancing, but information is power.
Best always,
David
________
** What does protection look like? At the extreme, it’s cash. As I mentioned last month, it’s OK to hold some cash. Cash is, in fact, a position. It means you’re prepared to act when circumstances better align with your risk tolerance.
Protection can also mean an overweight position in a model built for protection (i.e., Bond Bulls, Lean Muscle, The 12% Solution). It can mean putting multiple strategies to work in a portfolio, especially when those models tend toward an inverse relationship with each other, or focus on different asset classes or market sectors. Think Bond Bulls and American Muscle. Or Global Trader and The 12% Solution.
Because each strategy uses a slightly different mechanism to identify market risks, and because each can employ different funds representing different market sectors (although there is obviously some overlap), there is beneficial diversification at work when using multiple strategies within a portfolio – helping to reduce volatility and max drawdown.
Finally, protection can mean keeping an eye on the provisional picks during the month. These can provide a heads-up on potential trends -- and breakdowns of existing trends. Look for asset class shifts (a switch from an equity fund to a safe harbor asset like cash or bonds, or the contrary). See if such a shift holds up for a few days. Not every such move is a trading opportunity or justifies a rebalancing, but information is power.
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