Yield Curve Report


  • Yield curve inversion suggest caution, but hold equities
  • Rotate funds toward Utilities, Real Estate and Consumer Staples
  • Add hedge to the portfolio via Gold, Bonds and Gold Miners ETF
  • In case of increasing Baa spread, short HYG and JNK


The yield curve is one of the most used indicators in predicting economic slowdowns. The FED created even an index to identify the probability of a recession within twelve months from the date considered, as a matter of fact, the probability of a recession within twelve months is the highest in a decade as we can see in the following chart.

Probability of US Recession Predicted by Treasury Spread (10y-3m) by NY FED

One of the most important fact we have to keep in mind is that the 10Y-3m curve inversion anticipated the last two recessions, thus we need to allocate our assets in a proper way. From a global perspective, the manufacturing PMIs are still in contraction territory with most countries showing inverted yield curves.

As JP Morgan noted in August 2019, on average between the inversion of the curve (10Y-2Y) and the actual recession there are 22 months. Thus, we should expect a recession between 2020 and 2021. In the meanwhile, looking at historical data, can be seen that the stock market tends to climb higher despite the inversion of the curve, this is the most important fact to keep in mind along with the decision of FED with regards to interest rates, which are going to be cut toward 1% during 2020.

Portfolio Allocation

Despite recession probability is increasing, we want to keep at least a 40% equity exposure, along with 30% in bonds and 30% in precious metals. The last two just cited are the least interesting as they are a safe play in general slowing economic environment; on the bonds side, we suggest investing across all the curve, especially on medium-long term bonds using ETFs like TLT and IEI. While gold can be purchased via the GLD ETF.

In addition to the bond argument, during recession high yield bonds and junk ones underperform, thus in case of market turmoil these should be avoided and for more risk-lover investors we suggest even to short term. Although for the moment we are just seeing a slow pick up in credit spread, investors should keep an eye on the Moody’s seasoned Baa corporate bond yield relative to yield on 10-year treasury constant maturity as the cross of the 50 days moving average with the 200 days moving average has been a good timing indicator in spotting adverse market conditions as well as short signal.

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Moody’s Seasoned Baa Corporate Bond Yield relative to Yield on 10-Year Treasury Constant Maturity, via KOYFIN

We want to emphasize that ad hoc selection of equities can provide superb returns in a slowing economy. Indeed, if we analyse the data of the last three yield curve inversions followed by a recession, the outperforming stocks were mainly high-quality stocks, as JP Morgan noted in July.

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S&P500 Quality / S&P500 Relative performance by JP Morgan Beta Strategies

From our data mining, we have identified sectors which outperform during yield curve inversion and they are: utilities, real estate, consumer staples and gold miners. In fact, if we look at the normalized return chart, we can easily note how they have beaten the market since the first inversion on March 22nd.

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ETFs Normalized Returns from March 22nd 2019, via KOYFIN

Thus, for the 40% in equity must be allocated mainly in utilities via XLU ETF, in real estate via XLRE ETF, in consumer staples via XLP ETF and lastly in the GDX ETF for gold miners. The allocation into the latter should be little, about 15% of the total equity portfolio as we are already exposed to gold through the GLD ETF.

The portfolio illustrated above follows the idea of having low correlated assets with a macro approach. This type of funds outperformed during the last two recessions as we can see in the following chart.

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S&P500 and Macro Funds total return, indexed, via JP Morgan

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