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Yield Curves Invert for the Fourth Time Since 1997
On Tuesday, the highly watched 2 and 10-year yield curve went into an inversion, sending stock market commentators into depression.
“Historically, a recession has not happened without an inversion,” noted Ben Emons, global macro strategist with Medley Global Advisors LLC. “So likely, it will be a predictor of a future recession.”
Their morose outlook is understandable. The bond market phenomenon has preceded every recession since the 1950s. Rarely are such indicators so reliable (Even the soccer oracle Paul the Octopus only had an 86% accuracy rate).
But market bears are getting concerned too early. On average, the stock market has risen 12% in the first year following an inversion. This week, shares in some of the highest-risk meme stocks from GameStop (NYSE:GME) to AMC Entertainment (NYSE:AMC) have mounted some of their longest winning streaks since 2010. Cryptocurrencies have staged similar comebacks.
The party will eventually end. But in the meantime yield curves are still saying “buy, buy, buy.” Tactical investors should listen.
Bond Yields Have Inverted. Now What?
I know, I know — it’s hard to get excited about bonds. These fixed-income instruments don’t have the same upside as stocks… if they have any at all. Since 2020, the bond market’s largest ETF has fallen 5.2% on rate hike fears. No commonly-traded U.S. government bonds offer inflation-beating yields (You would be better off betting on Paul the Octopus’s soccer picks).
And the bond market’s predictive ability is sometimes questionable. Russian sovereign debt was still trading at par in the days leading up to its invasion of Ukraine.
Bond investors also seem to have the memory of a goldfish when it comes to basket cases like Argentina. In 2017, credulous investors managed to snap up $2.75 billion of the country’s 100-year “century bonds.” The country would default on those bonds just three years later (pretty fast century, if you ask me).
But fixed income markets still provide plenty of reliable warnings. 84% of countries rated “CCC” by Fitch default on their sovereign debts within 10 years. 40% of companies do the same. Equity analysts ignore their bond counterparts at their own peril.
What are Bond Inversions?
Bond yield inversions occur when the yields on shorter-duration bonds exceed those of longer-duration ones. It’s an unusual phenomenon because longer-dated bonds are meant to compensate holders for their higher risk.
A 2.5% yield on 2-year bonds and a 2.5% yield on 10-year ones signal a flat curve. A 2.2% yield on 10-year bonds would make it an inverted one.
From a theoretical standpoint, bond inversions happen when investors expect the Federal Reserve to tighten in the near-term before loosening in the long run.
Why do Bond Inversions Matter?
In practice however, bond inversions are most useful for stock investing because they signal overly loose monetary policy.
“The yield curve is influenced by more than monetary policy expectations… [but] in particular, we find that a monetary policy easing… is associated with an increase in the probability of a recession within the next year,” explains researchers at the Chicago Fed.
In turn, these inversions precede recessions because they share the same common denominator:
Faster-than-expected tightening by the Fed.
There are signs everywhere that this will eventually happen. Rising inflation… high asset prices… a meme stock repeat… the Federal Reserve faces far too much money chasing far too few assets. M2, a measure of cash in the economy, has risen 40% since the start of the pandemic.
As the Fed turns off the money taps, the opposite will happen. Tighter liquidity will sink speculative bets and “long-duration” stocks with low current profits.
Bond Markets Signal “Buy, Buy, Buy!”
Still, regular Moonshot readers will know that past inversions were phenomenal short-term signals to buy.
Consider what happened when bonds inverted in 2005:
- BP Prudhoe Bay Trust (NYSE:BPT). +289% in six months
- Enservco Corp (NYSEAMERICAN:ENSV). +194%
- Marine Petroleum Trust (NASDAQ:MARPS). +176%
- LSB Industries (NYSE:LXU). +176%
…Or in 2019:
- ChemoCentryx (NASDAQ:CCXI). 605%
- Kodiak Sciences (NASDAQ:KOD). 480%
- Applied Therapeutics (NASDAQ:APLT). 418%
- Immunitybio (NASDAQ:IBRX). +392%
When yield curves invert, high-momentum assets continue their winning streak for a little while longer. A hangover, after all, needs a big party to happen first.
The same scenario is now playing out today in stocks:
- Hycroft Mining (NASDAQ:HYMC). +735% in 1 month
- Houston American Energy (NYSEAMERICAN:HUSA). +254%
- GameStop. +42%
- AMC Entertainment. +40%
…And in crypto:
- Will Smith Inu (WSI-USD). +3372%
- ApeCoin (APE-USD). +1285%
- Zilliqa (ZIL-USD). +324%
- Waves (WAVES-USD). +309%
No matter where you look, investors seem to be shrugging off bond market fears.
It’s why earlier this week, I doubled down on my call for investors to buy up green energy stocks, particularly those with the ability to outlast an eventual recession. Other Moonshot picks from Longeveron (NASDAQ:LGVN) to Team (NYSE:TISI) have similarly done well. Markets tend to continue a bull run for 6 to 36 months after an inversion initially occurs.
What to Buy for a Bond Market Inversion
Buying during a bond market inversion still involves some thought, since not every industry benefits equally.
Inversions are particular headaches for commercial banks, which make money by borrowing from cheap short-term deposits and lending them out at higher rates for longer terms. Flat and inverted yield curves make it harder to profit from this form of arbitrage. Wells Fargo (NYSE:WFC) has lagged the S&P 500 by a staggering 11.5% over the past month and Citigroup (NYSE:C) has done even worse.
Many indebted firms will also struggle in the face of higher refinancing rates. Meme favorite Exela Technologies (NASDAQ:XELA) has dropped 34% in the past month on solvency concerns. So have other companies with abnormally large debt loads.
In other words, buying for a bond market inversion involves finding companies that 1) have significant inflation-protected assets and 2) don’t require external financing.
The winners cover a wide swath of Moonshot picks:
- Biotech. Successful biotech drugs are phenomenal protection against inflation, as Moonshot Entera Bio (NASDAQ:ENTX) has shown.
- Deep Value. My No. 2 pick Volt Information Science (NYSEAMERICAN:VOLT) has already been acquired at a 100% premium. Alternative Team has done similarly well.
- Energy and Mining. The ultimate inflation hedges are performing well as expected, with Cameco (NYSE:CCJ) rising 20% over the past month and Peabody Energy (NYSE:BTU) up 37%.
Other non-Moonshot firms can benefit too. Walmart (NYSE:WMT) has beaten the S&P 500 index by 7% this year as inflation-sensitive customers turn to cheaper options (Walmart was one of only two major stocks to rise during the 2008 financial crisis). And even car rental firm Avis (NASDAQ:CAR) is turning into a Wall Street darling thanks to the rising values of its vehicle fleet.
The Fed will eventually step in with higher interest rates. But until Jerome Powell rings the “top-of-market-bell” once more, tactical investors are better off buying up inflation hedges than sitting on the sidelines.
What If the Bond Inversion is Wrong?
In the face of inverting yield curves, some market commentators have dared mention:
“This time is different.”
To them, the widening spread between three-month Treasuries and 10-year notes is a stronger signal that markets are doing just fine.
They may have a point. The Fed’s unprecedented bond-buying program has distorted bond prices. A withdrawal by the Fed could send the yields of 10-year bonds rising, noted analysts at Reuters.
On March 25, the Federal Reserve went further by noting that the relationship between inverted yields and recessions is “probably spurious.”
Still, investors shouldn’t ignore the risks. Bond investors are signaling that the Fed will have to raise rates faster than expected. And with inflation still running hot, it’s far better to protect your portfolio than make bets without an eight-legged oracle named “Paul” by your side.
P.S. Do you want to hear more about cryptocurrencies? Penny stocks? Options? Leave me a note at moonshots@investorplace.com or connect with me on LinkedIn and let me know what you’d like to see
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On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.
