Summary. In response to the recent inversion of the U.S. Treasury yield curve, Red Tortoise’s investment committee voted to reduce the weightings to equity by 5% across all risk levels.
Unusual times call for unusual actions. We loathe trying to time movements in the stock market, and our capital market forecasts have a horizon of ten years. In this circumstance however, both data and theory support reducing equity exposure. Here we explain what the yield curve is, what its shape suggests, what inversion is and what it signifies. We also describe what has happened in the stock market after previous inversions. It bears repeating often and loud that past performance is no guarantee of future performance. We will also note our reasons why this time might be different. Finally, we discuss what might cause us to reverse the call or move further.
The interest rates implied by bond prices are called yields. For our purposes, we are only looking at the 10-year Treasury Note and the 3-month Treasury Bill. Here’s the concept. Interest rates are the prices paid for borrowing money. As demand for money increases relative to supply, rates rise. As demand falls, so do rates. In what’s called a normally shaped yield curve, the curve slopes upward meaning that interest rates on longer term bonds are higher than shorter term bonds[i]. An inverted yield curve occurs when the rates on longer term bonds are lower than shorter term bonds[ii].
When longer-term rates are lower than short-term rates the bond market is signaling that future demand for money will be lower suggesting a weaker economy, even a recession[iii].
At Red Tortoise, we believe markets work well (not perfectly), and investors discount what they expect to happen in the future. Markets try to predict the economy and as a whole do a reasonable job. Therefore, we don’t try to use current economic conditions to predict the future. Rather, we think the market is a predictor of the economy. The future is hard to predict, even for markets. So let’s look at some data.
Going back to 1962, we collected the data and found 51 events defined as when the spread between the 10-year and 3-month rates went from positive to negative. On average, the stock market as represented by the S&P 500 index was lower over the next 1, 3, 6, 9, and 12 months with the lowest average decline occurring at the 6 month mark.
In short, the economic theory that an inverted yield curve suggests a weaker economy ahead combined with historical data is the basis for our decision. The investment committee further decided that absent new information we would unwind the trade in 6 months again based on the historical record.
What could cause our call to reduce equities to go wrong? While the 51 inversions that we identified preceded negative stock market returns on average, not all were negative. About 2/3 were negative and 1/3 were positive, including one six-month period which was up 22%[iv]. So even based on history, the market may go up from here. Topping our list of what could go wrong is that the Fed might take action to stimulate the economy. Additionally, the government might take action which would be stimulative such as reversing tariffs.
Regardless of the outcome, we are comfortable with our decision because we have identified a risky environment even if the risk does not materialize, and because we have both theory and data to support our decision. We are in the uncomfortable position of hoping we are wrong, because we’d rather the market go up than down.
We will continue to monitor markets. Absent any changes we would unwind this trade in 6 months. We also might reverse the trade earlier should we see strong signs of strength. Should we see signs confirming greater weakness we also might further reduce our equity allocation.
(revised March 28, 2019)
[i] There are three main theories for the shape of the yield curve. The liquidity preference theory says lenders require more interest to lend money for longer periods. The preferred habitat theory says that some borrowers and lenders prefer particular time periods and this supply and demand dynamic plays out at different maturities. The third is the expectations hypothesis which is that the yield curve is a harbinger of future rates. For example, if the rate on one year borrowing is 1% and the rate for two years is 2%, then one can infer that the one year rate will be about 3% one year in the future. The idea is that the two year period is made up of two one year periods. If the first year is 1%, the second year would have to be 3% for the rate to average 2% over two years (we’ve used some simplified math here).
[ii] The yield curve inverted on March 22nd with the 3-month at 2.46%, and the 10-year at 2.44. Yesterday the curve was still inverted with rates at 2.44% and 2.39% respectively. Source: https://www.treasury.gov
[iii] We’ll be happy to send you additional research on this, just ask.
[iv] The 22% rise occurred after the inversion on October 28, 1974. The economy had entered into a recession in November of 1973 which ended in March 1975. The yield curve inverted on June 1, 1973. The investment committee looked at the 1974 inversion and concluded it was not representative of the current environment because we are not now in a recession.