Embrace the Inverted Yield Curve: Here's How

02/20/2020 9:32 am EST

Focus: STRATEGIES

Landon Whaley

Editor, Gravitational Edge

Pundits love to predict recessions based on yield curve inversions, but they cannot time them. However, these sectors soar during inversions, writes Landon Whaley.

This week’s “Headline Risk” focusses on how to properly position yourself for an inverted yield curve.

With 56% of all U.S. yield curves currently inverted, there is no shortage of media personalities and fearmongers trying to convince you that a yield curve inversion means it’s time to build a bunker loaded with canned food and ammo.

Often these folks look at past yield curves inversions and calculate the average time from yield curve inversion to a recession based on those occurrences. One recent example looked at the seven inversions that have occurred in the 10-year Treasury/three-month Treasury yield curve since 1969 and determined that, on average, a recession occurs within 311 days from the day the curve goes negative. This analysis concludes that the next U.S. recession will either occur in Q2 2020 or as late as Q4 2020.

I’ll keep my objection to this theory concise. Economic data is non-periodic, which means using historical averages like the aforementioned example to make timing calls is pointless.

Beyond that, a yield curve inversion is not the investing version of Nightmare on Elm Street 12. In fact, an inversion adds an additional bullish catalyst to markets we already like on the long side because of our U.S. Shift Work macro theme. So, what are those markets, and how have they reacted in the past?

Long-dated U.S. Treasuries

Beginning in 1988, the first yield curve inversion of significant duration lasted six months from December 1988 to June 1989, and long-dated U.S. Treasuries gained 9.6%. The second inversion lasted 10 months, from February 2000 to December 2000, and long-dated Treasuries gained 12.1%. The third inversion also lasted 10 months, from June 2006 to March 2007, and long-dated Treasuries gained 8.9%.

Not only are the returns more than palatable, but the average peak-to-trough drawdown experienced during these inversions was just -4.1%. With an average gain of 10.1%, the reward-to-risk ratio is more than 2-to-1 in favor of the upside. How you like them apples.

Utility Sector
During the 1989 inversion, U.S. utilities gained 13% with just a 6.3% drawdown. During the 2000 inversion, utilities gained a whopping 40.8% while experiencing a -16.1% maximum drawdown. And finally, in the 10-month inversion from June 2006 to March 2007, utilities put up a 27.4% gain with just a -5% drawdown. With an average gain of 27.1% and an average drawdown of just 9.1%, the reward-to-risk ratio is approximately 3-to-1 in favor of the upside. Utilities are the very definition of “low risk, high reward” when the concerning inverted yield curve makes an appearance.

REITs

Treasuries and utilities aren’t the only asset classes that enjoy a good inversion. REITs are bullishly inclined in that environment as well. During the 1989 inversion, U.S. REITs gained 8.3% with just a -0.3% drawdown. During the 2000 inversion, REITs earned a healthy 22.4% return while experiencing a 9.9% maximum drawdown. And finally, in the 10-month inversion from 2006 to 2007, they rallied 27.7% with a 12.6% drawdown. With an average gain of 19.5% and an average drawdown of 7.6%, the reward-to-risk ratio is a very tradeable 2.5-to-1 in favor of the upside.

The “Headline Risk” bottom line is that an inverted yield curve is not something to be feared; it’s something to be harnessed. The U.S. Fundamental Gravity is already conducive to a bullish move in utilities, REITs, and Treasuries, which is why all three markets are currently busting moves to brand new all-time highs. Remember, an inversion in the U.S. yield curve is throwing one more Molotov cocktail on an already bullishly burning car.

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