Edition #210
Yield Dynamics, Curve Inversions & Market Implications
Investors,
In last week’s premium report, I expressed my short-term bullishness on U.S. equities. Unfortunately, I was wrong.
While I acknowledged downside risks and the broader macro headwinds, I thought that risk assets were prepared to experience a short-term rally higher. This expectation was based on a few components:
U.S. Dollar Index Divergence vs. Risk Assets: While the $DXY reached new YTD highs, stocks had failed to make new YTD lows. With the dollar starting to rollover and stocks gaining upside momentum, I thought this trend might continue for a bit longer.
Improved Under-the-Hood Metrics for the S&P 500: As of last Friday, underlying components of momentum were improving on a short & medium-term basis. Again, I thought that this would continue for a bit longer.
Disinflation in August 2022 CPI: Market consensus was that the YoY August CPI would be lower than the July level. I agreed with that perspective, and the data eventually confirmed this to be true. However, inflation came in higher than estimates & projections. Because of the miss vs. expectations, risk assets fell substantially following Tuesday’s release of the data.
While the first two factors were indeed true, the release of the August CPI threw a wrench in my analysis; although I repeatedly highlighted the risks of my perspective. Regarding the CPI data, I said the following:
“More specifically, I think asset prices could rally strongly if we see a month-over-month decline in either the headline or core CPI data.”
Considering that we saw a month-over-month increase in both the headline & core CPI, my bullishness was invalidated. In this sense, I correctly identified the risk associated with the CPI data. In addition, I provided clear risk parameters should the market turn against me. I put my money where my mouth was, took a swing and missed. I’m okay with that.
“I could certainly be wrong, but I took meaningful short-term trades during Friday’s session for the first time in several months. If I’m wrong, I’ll cut these positions at a max loss between -10% and -15%.
Indeed, I cut my positions at a loss of -12% on Tuesday afternoon. While this might be considered a loose stop-loss, I believed that this was the right decision based on the potential upside of the trade. The parameters of the trade were simple:
Take profit at potential gain of +52%
Take loss at maximum gain of -12%
Risk/reward = 52/12 = 4.3
In my mind, a trade with a potential risk/reward larger than 3 is extremely attractive. While I lost on this trade, I still think it was a worthy at-bat. I properly acknowledged the risks, fundamental catalysts, and had a risk management strategy in place. Trading around news events is a difficult tasks, leaning more towards speculation than sound trading. In this case, I thought the news event could provide an upside catalyst. In the future, I’ll do a better job of avoiding these types of trades.
I will always be transparent about my personal views, market interpretations, and portfolio decisions. At the end of the day, this newsletter and the premium insights that I provide are intended to share my perspectives on markets, digest new data & reconcile it against my existing investment thesis. My promise since day 1 has been to provide objective analysis supported by data, and this will continue to be intention going forward.
I won’t shy away from my losses or mistakes. In fact, I think it’s vital to share them and hold myself accountable to each of you. As they say, “you win or you learn”.
In today’s premium report, I will share an exclusive new study that I haven’t conducted before in order to measure the impact of a 100% success rate signal: the inversion of the 10-year Treasury yield vs. the 3-month Treasury yield. Initially discovered and popularized by Harvey Campbell, a finance professor at Duke University, the 10yr/3mo inversion is considered to be the ultimate signal to predict an upcoming recession.
While this relationship has yet to invert, it’s worthwhile to understand the implications in terms of stock market performance once this signal occurs.
In addition to this study, I’ll share under-the-hood S&P 500 metrics, yield analysis, and other key charts that I found intriguing as part of my weekly research.
Yield Curve Inversion, Coming Soon?
It’s vital to understand what an inversion of the curve means why it’s an important signal to identify economic/financial anomalies. An inversion simply indicates that the yield generated on a shorter-duration asset, like the 3-month Treasury yield, is greater than the yield that can be generated on a longer-duration asset, like the 10-year Treasury yield.
Intrinsically, this occurrence violates one of the core fundamentals of finance: the time value of money.
The time value of money simply states that a dollar today is worth more than a dollar in the future, because that dollar can be spent, invested, or saved today. Whether we receive a dollar tomorrow or 2 years from now, the dollar today is worth more. Therefore, there’s an intrinsic gap in value between owning a dollar right now vs. owning a dollar at some point in the future. This gap in value is the interest rate, providing a rate of return in order to compensate for not owning a dollar right now in order to receive a dollar in the future. By receiving a dollar in the future plus interest, an investor would be willing to forego the value of owning a dollar right now.
The longer an investor must wait to receive their dollar back, often referred to as the maturity, the more the investor must be compensated. Hence why a 1-year Treasury yield is less than a 30-year Treasury yield! Considering that the investor is lending their capital for an additional 29 years, foregoing the benefit of spending that capital today, it only makes sense that they’d be compensated for the extra delay!
This basic premise is arguably the core underpinning of finance, highlighting the necessity of interest rates to allow capital markets to function properly.
With this understanding in mind, we recognize that an inversion of the curve violates this basic premise of financial markets. If there isn’t a marginal return for lending money over a longer period of time, there isn’t a financial incentive to lend for a longer period of time! This means that capital-intensive projects/assets that must be financed over a 5, 10, or 30-year maturity will be disincentivized vs. a project/asset with a 1-year maturity.
In other words, it creates distortions across a financial & economic system, incentivizing capital (a scarce resource) to flow towards a sub-optimal outcome. Considering that the goal of economics is to optimize the allocation of scarce resources, the sub-optimal environment created by an inverted curve is undesirable.
At the present moment, a variety of different inversions have occurred. As of Friday’s close, here are the notable inversions:
The 10-year Treasury yield vs. the 2-year Treasury yield (2/10).
The 10-year yield vs. the 5-year yield (5/10).
The 5-year yield vs. the 2-year (2/5).
The 30-year yield vs. the 5-year yield (30/5).
The 2-year yield vs. the 1-year yield (2/1).
and many other variation.
The point of this breakdown is to simply acknowledge that distortions exist across a wide array of time lengths. While each of these are concerning, the Godfather of yield curve inversion analysis, Harvey Campbell, has acknowledged that the specific inversion of the 10-year Treasury yield and the 3-month Treasury yield is the key relationship to monitor. In fact, it has successfully predicted 8 of the past 8 recessions, achieving a 100% success rate.
This brings us to the inevitable question: where is the 10-year yield vs. 3-month yield right now?
While it isn’t negative yet, the spread between the 10yr/3mo has fallen off a cliff, currently measured at 0.282% as of Friday’s close. Analyzing this chart in and of itself doesn’t provide much context, as it’s difficult to understand how impactful this datapoint truly is in isolation. As such, I’ve added the S&P 500 in the lower-bound of the following chart, isolating the month that the 10yr/3mo became negative & then became positive once again:
Unfortunately, the data that I have access to only goes as far back as 1990, so the extent of this analysis is limited. Nonetheless, I think the implications from these three signals is clear: the inversion of the 10yr/3mo curve is a viable leading indicator, which therefore predicts a stock market downturn in the near future.
Here’s how the S&P 500 performed in each of these three prior signals:
July 2000 Signal:
3-month Return: 0%
6-month Return: -5%
1-year Return: -15%
2-year Return: -36%
5-year Return: -14%
Max Drawdown From Signal Date: -46%
Max Drawdown After Signal (peak to trough): -49.5%
August 2006 Signal:
3-month Return: +7.3%
6-month Return: +8%
1-year Return: +13%
2-year Return: -1.5%
5-year Return: -6.3%
Max Drawdown From Signal Date: -48.8%
Max Drawdown After Signal (peak to trough): -57.7%
May 2019 Signal:
3-month Return: +6.4%
6-month Return: +13.8%
1-year Return: +10.3%
2-year Return: +52.5%
5-year Return: ???
Max Drawdown From Signal Date: -20.2%
Max Drawdown After Signal (peak to trough): -35.3%
Average Returns:
3-month Return: +4.6%
6-month Return: +5.6%
1-year Return: +2.8%
2-year Return: +5%
5-year Return: -10.2%
Max Drawdown From Signal Date: -38.3%
Max Drawdown After Signal (peak to trough): -47.5%
I was rather intrigued by these datapoints, because I was impressed at the resilience we see across a variety of return timeframes. Despite the resilience of the average return data (only the 5-year average return is negative), the average maximum drawdown data highlights unequivocal pain as a result of this signal.
This tells me something very important: the inversion of the 10yr/3mo is not an effective market timing mechanism, but simply signals that pain is around the corner. This signal doesn’t tell us how far away we are from the corner, but it does tell us that it won’t be pretty once we get there.
Additionally, deep market drawdowns can occur without the inversion of the curve. As we’re seeing in the present environment, the 10yr/3mo curve hasn’t inverted but the S&P 500 is currently down -19.5% from the 52-week highs. I’m curious to know what this could imply about market conditions if/when the curve does invert…
As the spread continues to trend towards 0%, I will continue to monitor this dynamic and flag any updates that are important. At the present moment, we seem to have an “all clear”, but that could certainly change.
Under-the-Hood S&P 500 Metrics:
This past week was the worst weekly return for the stock market since June 2022. In addition, Tuesday’s -4.3% decline was the worst since June 2020.