During the FOMC meeting in early May, Fed Chairman Powell hinted at a "halt to interest rate hikes." Meanwhile, the interest rate market have already pricred in at least two 25 bps rate cuts by the end of this year. For reference, the current benchmark rate is 5%-5.25%.
Therefore, barring any major surprises, the deep inversion of US Treasuries yield curve is already on the path to bottoming out and rebounding.
So, during the process of transitioning from an inverted yield curve to a positive one, how will major asset classes around the world perform? What investment opportunities will arise? Let's look at how the data speak:
Six instances of yield curve inversion over half a century
As the name suggests, yield curve inversion happens when a yield curve graph of (typically) government bonds inverts and the shorter term bonds are offering a higher yield than the long-term bonds.
Generally, yield curve inversion is measured by looking at the comparisons of 10Y Treasury yield - 2Y Treasury yield (10Y-2Y) or 10Y Treasury - 3M Treasury yield (10Y-3M).
We analyzed monthly frequency data on US Treasury yields from 1976 to the present, considering both the 10Y-2Y and 10Y-3M indicators, and identified six distinct periods of yield curve inversion, as shown in the graph below:
Source: Bloomberg and Tiger Trade
Among these six instances of yield curve inversion, the longest period of inversion occurred in the late 1970s and lasted nearly 4 years. The shortest period occurred before the pandemic, lasting 8 months.
If the Fed had not started cutting rates in the second half of 2019, the previous inversion period would likely have been even longer. Furthermore, major events occurred before and after each inversion period, and the US economy experienced a recession within two years after each inversion.
Source: Bloomberg and Tiger Trade
2. Widening vs. narrowing of the inversion
According to the description of yield curve inversion, we divided the period of yield curve inversion into two phases:
Widening phase: From the start of inversion to the spread minimum, Fed continuously raised short-term interest rates, intensifying the inversion during this period.
Narrowing phase: From the spread minimum to the end, Fed stopped raising rates or started cutting rates, suppressing short-term interest rates and alleviating the inversion during this period.
We analyzed the average returns of four major assets — $S&P 500(.SPX)$ , US 10Y Treasury bonds, gold, and commodities—during the widening and narrowing phases of the five above-mentioned yield curve inversion periods. The results show that:
Stocks, gold, and commodities performed significantly better during the widening phase of the inversion.
In contrast, US 10Y Treasury bonds performed noticeably better during the narrowing phase of the inversion.
Source: Bloomberg and Tiger Trade
3. Performance of major assets after the yield spread bottoms out
Based on the data of five previous yield curve inversions, we analyzed the performance of major assets during different time periods after yield spread bottoms. By comparing the results, we found that:
• Within one month after the bottoming out, all major assets declined, with gold exhibiting significant probability and magnitude of decline.
• After the bottoming out 2-3 month, bonds showed the most noticeable upward trend, with a substantial increase in the probability of an upward movement.
• From 3-6 months after the bottoming out, stocks and gold begin to rebound comprehensively, while bonds continued to rise.
• Between 6-12 months after the bottoming out, stocks, bonds, and gold all exhibited favorable performance.
Considering the overall returns and possiblities, bonds appear to performs better after spreads bottom, while investors may avoid gold within the first three months after the bottoming out.
Source: Bloomberg and Tiger Trade
Source: Bloomberg and Tiger Trade
4. Summary: Bonds take the lead after spreads bottom
Looking beyond the surface, the rate hikes by the Federal Reserve can be seen as a potent medicine for the market.
On one hand, it can suppress inflation from the demand side; on the other hand, it can lead to adverse consequences such as unemployment and yield curve inversion.
For instance, in the current rate hike cycle that began in 2022, the interest rates in the US have experienced a significant inversion over a period of more than a year, with an increase of 500 basis points.
Now, as the Fed is likely approaching the peak of rate hikes, we find ourselves at the juncture of spreads bottoming out. Historical data suggests that bonds may be an ideal asset for the next few months or even the second half of the year.
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