Bond markets are often hailed as a precursor to equity markets. Yield curves plot the interest rates of bonds by their maturities or time until repayment. They reflect what future expectations bond investors have on interest rates and economic activity. Our research into yield curves has allowed us to broadly time the market. Upon observing a yield curve inversion, we were risk-on in 2019 and risk-off in early 2020 in anticipation of a top in markets. Then upon observing unconventional central bank intervention and a return to a normal yield curve, we pivoted to risk-on in the subsequent months.
2. YIELD CURVE INVERSION
On 4 December 2018, the US2Y yield exceeded the US5Y yield, inverting the yield curve for the first time since the Global Financial Crisis. Our predictive model based on the past seven US recessions indicated that the market was due for a rally before peaking in 19 to 24 months in anticipation of another recession. We understood that each recession is unique and thus paid close attention to global macroeconomic indicators that could prompt a deviation from our initial assumptions. Namely, we viewed the emergence of COVID-19 globally in January 2020 as the catalyst to bring forward an impending recession and major market correction.
2.1. Why the Yield Curve Inverts
An inverted yield curve signals that bond investors believe that a recession is due in the short to medium term. The inversion itself will not cause a recession.
Normally, longer-term bonds have a higher yield than shorter-term bonds due to the higher inflation risk and interest rate risk that longer-term bonds face. During a recession, inflation and interest rates may fall materially, causing longer-term bonds to attract a negative risk-premia. Investors will seek to “lock in” the yield of longer-term bonds in anticipation of likely interest rate cuts.
Typically, a yield curve inversion coincides with the end of an interest rate hiking cycle. This can be bullish for markets given that cutting interest rates will reduce the discount rate applied to equities. Federal Reserve chairman, Jerome Powell, used a relatively more dovish tone in his speech on 28 November 2018, which was one of the initial signals for a pivot in monetary policy and prompted a yield curve inversion on 4 December 2018.
2.2. Timing the Top
To optimise the reliability and usefulness of our market timing model, we analysed 50 years of data and seven US recessions. A yield curve inversion preceded the last six of seven recessions, but equity market returns were materially higher leading up to a recession. Thus, timing and precision are paramount to avoid de-risking too early and underperforming in a bull market.
We analysed the time it took for markets to top after certain points in the yield curve inverted. The US2Y/US5Y and US2Y/US10Y inversions had the optimal balance between sufficient data points (reliability) and sufficiently small ranges (accuracy). The 80% confidence interval was 19 to 24 months until a market top for a US2Y/US5Y inversion.
Using a similar method, we found that markets typically returned between 12% to 20% over 12 months after a US2Y/US5Y inversion, providing further justification of being risk-on in 2019. In actuality, the ASX 200 rose 16% in the 12 months after the inversion, the midpoint of our estimate. Whilst our model suggested a market top was not due until at least July 2020, our analysis of COVID-19 in January 2020 prompted us to de-risk in favour of a prevailing catalyst.
3. UNCONVENTIONAL MONETARY POLICY
Quantitative easing or bond repurchases is an unconventional tool used by central banks to stabilise the short end of the yield curve and flood the market with liquidity. It has historically facilitated broad-based liquidity rallies in the short term and encouraged us to pivot to risk-on in the months following the March 2020 crash. Central banks can also engage in yield curve control to stabilise the long end of the curve, providing another backstop to equity markets.
3.1. Quantitative Easing
To minimise the risk of a liquidity crisis, the Federal Reserve conducted quantitative easing and has repurchased over $2.6 trillion in treasuries since March 2020. For context, about $2 trillion in treasuries were repurchased in the decade after the Global Financial Crisis.
Treasuries were repurchased investment banks and institutional investors, flooding the market with liquidity and driving M2 money supply growth by a record 25% YoY in the US. As interest rates have also been cut to 0.1%, investors were forced up the risk curve into equities to mitigate inflation risk.
3.2. Yield Curve Control
Bond repurchases have typically been conducted on shorter duration bonds, keeping the short end of the curve low. The long end of the yield curve has remained sensitive to free-market forces with the US10Y yield trending higher from 0.5% to 1% over 2020. Consequently, the yield curve re-steepened from inverted back to normal.
A steeper yield curve encourages banks to lend given they borrow at the short end and lend at the long end. The boost in credit liquidity should stimulate economic activity and boost earnings for cyclical companies.
However, a rising US10Y yield can also be viewed as a negative for the broader market as it increases the discount rate applied on free cash flows. Should economic conditions deteriorate, central banks can intervene through yield curve control and aggressively purchase long-dated treasuries to further push down the cost of borrowing. This offers downside protection in equities against further negative economic shocks.
The Reserve Bank of Australia is currently using yield curve control to stabilise the AU3Y at 0.1%. Consequently, the AU10Y has been relatively more stable and Australian equities on average remain less volatile to US counterparts.
The yield curve has allowed us to more reliably time equity markets and adjust our market risk exposure more effectively. Because of our data-driven approach, we were able to produce a narrower and more useful range of ASX 200 predictions which have been pleasingly accurate. We remain optimistic in markets considering ongoing central bank intervention.
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