When 3-Month and 10-Year Yields Invert, How Should Investors React?

On Friday we saw the yield curve for the 3-Month Treasury and 10-Year Treasury invert for the first time since 2007. That certainly helped fuel the stock market's decline. I think much of that selling was overdone, as I wrote on Friday, but let's take a closer look at inversions and what I think is the key driver -- the U.S.-China trade deal. We Don't Trade Recessions I know people who trade all sorts of exotic and esoteric things. Heck, one good friend was just approached about trading volatility on bitcoin, which is at the extreme end of esoteric, but I don't know a single person who trades recessions. I will concede that the 3-month and 10-year yield curve inverting has been a reasonably useful leading indicator of a recession, though with varying amounts of lag time. But what really matters, is whether this is a signal that we can profit from. The S&P 500 - Maybe an Opportunity to Catch a Short-Term Selloff? Maybe In 1998, the S&P 500 rallied sharply after this signal. This was the first time I truly remember the Greenspan Put being implemented and Wall Street banding together to save Long Term Capital Management. In any case, viewing that inversion as an opportunity to exit risk would have caused you to miss out on an extended rally. Then in April 2000, the S&P 500 flatlined for several months before selling off. In this case it wouldn't have hurt to use this as a de-risking signal, but the decision still didn't pay off immediately (for the purists out there, the Nasdaq sold off for a couple of days after the signal, hitting a low on April 11, before it started a grind higher until September, when the real selling began again in earnest). As a short-term trader, you could have made a bit of money for a few days, but the real break lower in stocks didn't occur for months. Shorting Anything in 2006 Was Just Difficult The S&P 500 initially went higher, though it did slide after that, hitting a low in June 2006. After that, stocks marched higher and higher. We got another dip in the summer of 2007, but it didn't reach the 2006 lows and was turned into an extremely painful (at least for me) short-squeeze rally as the Fed took steps to avert the crisis (they encouraged use of the discount window, etc. in the summer of 2007 and somehow managed to send stocks to new highs even after the problems with mortgage portfolios had been exposed). The first signal produced the least potential trading opportunities. The other signals created some potential bearish trades, but the bigger selloffs were some way to come. Based on the last two times this occurred, it looks like it would be worth a shot at cutting risk, but it isn't conclusive. It is also worth noting that 3-month LIBOR was above 5% heading into each of the prior inversions. You could view that as bearish, because it means the Fed has a lot less room to cut rates today, then they did back then. The positive spin would be that 5% short-term rates is a real impediment. Or that a slowdown occurring with 5% rates is a real problem, while a slowdown occurring when rates are already low, might not have the same repercussions. 10-year yields responded to this inversion being hit by rallying once, selling off once, and remaining relatively unchanged once, so no conclusive direction. Since the 10-year yield is just above its Great Financial Crisis low of 2%, my vote is for meandering yields if not higher yields. The abject fear that was in the market in 2008 isn't present, yet 10-year yields are almost at the same level? From this, I can see that all else being equal it is worth reducing risk, but that is far from conclusive. Which leads us to the next obvious question: Is all else equal? Trade Deal or Bust? I see a U.S.-China trade deal as a binary event. We get it and markets go higher (despite or because of the overwhelming sentiment that the news should be sold). We don't get it, or it keeps dragging on and it is likely that stocks start heading toward their December lows, with the only question being how quickly they get there. I have spoken to a lot of companies and I think the risk is that the longer we go without a deal, the more entrenched they become in alternative solutions which would mitigate the benefit of any trade deal. Time is of the essence! Bottom Line While still bullish I advocate for putting on some hedges: Mid to late April out-of-the-money puts on the S&P 500. Really looking for relatively short-dated tail risk protection. The current market structure has a tendency to create long grinds higher, intermixed with steep and rapid declines. With volatility still relatively cheap, and stocks still hovering near recent highs (the S&P 500 did close at 2800 after all) this makes sense. On the credit front, puts on high-yield ETFs. The combination of low yields and massive inflows that have driven high-yield spreads tighter leave this sector the most vulnerable. I think investment-grade bonds can outperform and leveraged loans are so out of favor relative to high yield, they'll outperform. I'm cautious enough that I would add some tail risk hedges, but that is as much about concern on a potential trade deal as it is on inversion.

When 3-Month and 10-Year Yields Invert, How Should Investors React?

This yield curve inversion has been a useful leading indicator of a recession, but what really matters is whether it is a signal we can profit from.

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