The guest commentary below was written by Joseph Y. Calhoun, III of Alhambra Investments on 5/3/21. This piece does not necessarily reflect the opinions of Hedgeye.
The yield curve inverted last week. Well, the part everyone watches, the 10-year/2-year Treasury yield spread, inverted, closing the week a solid 7 basis points in the negative.
The difference between the 10-year and 2-year Treasury yields is not the yield curve though. The 10/2 spread is one point on the Treasury yield curve which is positively sloped from 1 month to 3 years, negatively sloped from 3 years to 10 years and positively sloped again from 10 out to 30 years:
So, yes, parts of the yield curve are inverted but the short end of the curve remains fairly steep. That is an unusual situation with no recent comparable periods (back to the 1978 inversion).
Typically, 10/2 inversions occur when the entire curve is flat with maturities shorter than 2 years going on to invert later at varying frequencies. So what does the current shape of the curve mean? The Fed is a follower on rates, not a leader, and if the market really believed the Fed’s hawkish rhetoric, I don’t think the front end of the curve would be this steep.
Or it could just be due to a lot of uncertainty about the Fed’s path to higher rates. One thing is sure; as the nature of the economy reveals itself over the coming months, the yield curve will continue to change – at the market’s pace, not the Fed’s.
Rates markets will anticipate any growth or inflation slowdown or acceleration long before it is apparent in the economic stats.
The 10/2 term spread is important to our investment process because it has a good track record for predicting recession, having inverted prior to every recession back to the 1950s (with one false signal).
So, when it inverts we do take it seriously and there are implications for our portfolios. The inversion of the 10/2 curve is an important signal for the bond portion of our portfolio but not nearly as much for the equity piece. 10/2 inversions in the past have often coincided with peaks in the 10-year Treasury yield and as such, they represent opportunities to extend the duration of your bond portfolio.
That doesn’t mean you should bet the farm on lower rates and buy all 30-year bonds. But if you’ve been holding short duration bonds as rates have risen – as we have – it is logical to take on some duration risk now by moving out to the intermediate part of the curve (say, 3 to 7 years).
As for stocks and other risk assets, the inversion of the 10/2 part of the curve doesn’t offer a definitive signal. The inversion is generally followed by a recession 6 months to 2 years later but there is no way to know in advance the time to the onset.
Stock performance after an inversion is mixed but with a bullish bias. The 10/2 spread has inverted 6 times since 1978 (assuming at least six months since the prior inversion) and the average return 1 year later is 13.4% with 5 of the 6 periods positive (the exception was the 2000 bear market when it was down 2.53% one year later).
The average return for 3 and 6-month periods are also positive (3.37% and 1.61%) but only 4 of the 6 periods were positive. To make a strategic change to our risk asset allocation we would need to see further evidence of imminent recession. We don’t currently have any such evidence.
When I started in this business over 30 years ago, no one talked about the yield curve except the bond nerds. Most of the research on the yield curve and recession wasn’t done until the late 80s and it takes time for this stuff to filter down to the masses, even within the industry.
Now, seemingly everyone knows about the yield curve, that when it inverts recession is on the way. And, predictably, we saw a plethora of articles, podcasts, and tweets last week about the inversion of the curve and the fact that it signals recession.
It is so well known today that there is even a Redditt about the yield curve. So, if everyone knows about the yield curve and takes action in their portfolio in anticipation of the recession it predicts, does the inversion mean the same thing it did 30 years ago?
Since everyone knows that everyone knows about the yield curve, is it possible that some took actions in anticipation of an inversion and by doing so actually caused it?
I don’t know but I learned a long time ago that there are no sure things in this business. And that things that are well known are probably not the things you should be focused on – they’re already in the market.
In my 30 years in this business and 40 years as an investor, I have seen many things happen that weren’t “supposed” to happen and a few things happen that we thought were impossible. Could the yield curve be wrong this time? I wouldn’t bet on it but the fact that it has become so well known does give me pause.
Having said that, I will not dismiss this inversion as nothing. The track record of the 10/2 yield curve is strong and cannot be ignored. So, acknowledge it, respect it, and take actions that are backed by historical evidence.
History says that the inversion is a good time to take on some duration risk in the bond portion of your portfolio but realize there isn’t a lot of data to base that on. Don’t take it as gospel and make a big bet on long-term bonds. History also says this isn’t a time to upset the risk side of your portfolio until more evidence about the economy points to recession.
For instance, we would expect to see credit spreads widen prior to recession and so far that just hasn’t happened to any significant degree. Spreads widened briefly but not to anywhere near the levels associated with recession or stock bear markets. And they have since narrowed.
The inversion of part of the yield curve is a warning but it is only a possible first step to recession. Don’t assume you know how the next steps will proceed and at what pace.
Even assuming the 10/2 term spread retains its predictive value (and it probably will), it tells you nothing about how we get from here to recession.
The journey promises to hold a lot of surprises.
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EDITOR'S NOTE
Joe Calhoun is the President of Alhambra Investments, an SEC-registered Investment Advisory firm doing business since 2006. Joe developed Alhambra's unique all-weather, multiple asset class portfolios. This piece does not necessarily reflect the opinions of Hedgeye.
