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One thing I have learned in my career on Wall Street is the yield curve truly is a leading indicator of current and expected financial conditions. The main stream media is doing a great job of reporting on the fact that the yield curve is happening. However, how to position your portfolio is being left out of all this yield curve chatter, which might be most important. Nevertheless, we first need to talk about what an inverting yield curve is and what it means for all of your qualified and non-qualified assets.
A Simple Explanation of An Inverting Yield Curve
An inverted yield curve is when long-term debt instruments have a lower yield vs short-term debt instruments of the same credit quality, such as United States Treasuries. This particular type of yield curve example everyone is talking about is the rarest of the three main curve types and is considered to be a text book predictor of an impending economic recession. A recent example is when the U.S. Treasury curve inverted in late 2005, 2006, and again in 2007 before U.S. equity markets collapsed. The curve also inverted in 2018. An inverse yield curve predicts lower interest rates in the future as longer-term bonds are demanded, sending the yields down.
The yield curve has inverted before every U.S. recession since 1955, suggesting that an economic downturn could be coming.
One thing investors have to know is the inverting yield curve does not mean the economy has to enter into a recession right then and there. According to Credit Suisse, when the yield curve inverts, it often suggests the economy will enter into a recession within an 22-month average time frame. It is an indication that the economy may enter into a recession in the near future. Instead of looking at an actual curve like most commentators are illustrating, lets take a look at a Treasury Rate table below:
| TERM | YIELD | CHANGE |
|---|---|---|
| U.S. 3 Month Treasury | 1.992 | 0.018 |
| U.S. 1 Year Treasury | 1.784 | 0.01 |
| U.S. 2 Year Treasury | 1.598 | 0.029 |
| U.S. 5 Year Treasury | 1.495 | 0.028 |
| U.S. 10 Year Treasury | 1.611 | 0.034 |
| U.S. 30 Year Treasury | 2.103 | 0.051 |
(Source: CNBC)
One observation I would like investors to take away from this table is the yield of 30-year treasury. One reason for such low rate is investors are nervous about future economic conditions, and are willing to buy longer dated bonds. This is the simple and fundamental reason why the curve is inverting. With the Fed now seeing the 30-year paying close to what a 3-month is, the Fed will continue to act while attempting to normalize the curve. They can do this by lowering the Fed’s discount rate, and potentially entering new quantitative easing policies. Both of these tools will help long bond holders make money.
Trading The Inverting Yield Curve
When I read articles about the yield curve inverting, I always wonder why investment professionals don’t recommend investment options to benefit from this? When global economies are heading into a recession, interest rates globally tend lower. Knowing this, investors are more willing to invest in longer-term securities immediately to lock in the current higher yields. It also doesn’t help when countries like Germany are offering 30+year interest rate products that have a negative yield. Since 2016, more than $3 trillion of bonds has been sold with a negative yield at issue, according to data from Barclays. This also puts pressure on our treasury markets as investors want a positive return here in our country, while having the guarantee of the United States of America.
An ETF to purchase in your fixed income portfolio, which provides correlation to lower rates and a chance for principal appreciation is the iShares Barclays Aggregate Bond Index ETF (AGG). The AGG ETF seeks to track the investment results of the Bloomberg Barclays U.S. Aggregate Bond Index. The index measures the performance of the total U.S. investment-grade bond market. This a great way for an investor to own bonds while not purely trying to bet on where the interest rate market will head. Lets take a look at a chart below if its performance as well:
Data by YCharts
As you can see, the AGG has produced a one-year return of 9.52% while not owning any common stocks. The trend of this performance is likely to continue as global economies slow.
Putting It All Together
I wanted to add a simple return table that summarizes how well the AGG performs when economies slow and yield curves invert. The italicized years are years where yields are inverting, and bold years are years when economies are in recession. Lets take a look below at this table:
| Year | Barclays Agg. |
| 1980 | 2.71% |
| 1981 | 6.26% |
| 1982 | 32.65% |
| 1983 | 8.19% |
| 1984 | 15.15% |
| 1985 | 22.13% |
| 1986 | 15.30% |
| 1987 | 2.75% |
| 1988 | 7.89% |
| 1989 | 14.53% |
| 1990 | 8.96% |
| 1991 | 16.00% |
| 1992 | 7.40% |
| 1993 | 9.75% |
| 1994 | -2.92% |
| 1995 | 18.46% |
| 1996 | 3.64% |
| 1997 | 9.64% |
| 1998 | 8.70% |
| 1999 | -0.82% |
| 2000 | 11.63% |
| 2001 | 8.43% |
| 2002 | 10.26% |
| 2003 | 4.10% |
| 2004 | 4.34% |
| 2005 | 2.43% |
| 2006 | 4.33% |
| 2007 | 6.97% |
| 2008 | 5.24% |
| 2009 | 5.93% |
| 2010 | 6.54% |
| 2011 | 7.84% |
| 2012 | 4.22% |
| 2013 | -2.02% |
| 2014 | 5.97% |
| 2015 | 0.55% |
| 2016 | 2.65% |
| 2017 | 3.54% |
| 2018 | 0.33% |
(Source: The Balance)
When looking at this table, you can see the AGG and Barclays Aggregate Bond Index is a steady return provider. As stock volatility continues to increase, it will be imperative investors add simple ETF’s like AGG to their portfolio’s. During the 2000-2002 bear market, the Barclays Aggregate Bond Index returned 30.32%. The S&P 500 lost over -43.1% during the same period. During the 2008 recession, the AGG returned 5.24% while the S&P 500 fell over -37%. Both large drawdown time frames were lead by an inverted yield curve.
Trade Summary
Owning the AGG is a very simple, yet very effective way to earn positive returns while yield curve inversion deepens. When writing this article, I was going to include the popular iShares 20+ Year Treasury ETF (TLT), and decided against it. Owning AGG can produce alpha and positive returns in any type of market, and not just lower interest rate markets like the TLT. Owning a pure Treasury ETF is a pure bet on interest rates lowering or staying the same, period. AGG will also allow you to sleep well at night, knowing if we do have a large drawdown in equities, you can then position your portfolio more aggressive after a sell-off happens. When reviewing your portfolio, make sure you have a core holding in an ETF like AGG, to profit off inverted yield curves, and a slowing economy.
Disclosure: I am/we are long AGG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Ortner Capital consults clients who own AGG and SPY securities. Please consult your own professional before making any transaction. This article is not advice, but that of professional opinion of Mr. Josh Ortner, CTFA.
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