Three Moves to Make after the Bond Market Flashed This “Danger” Signal 

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The U.S. bond market just flashed a signal that’s presaged just about every recession for the past 60 years.

But this signal tells us about the economy, not the stock market, and it’s important to see the difference.

It’s all about something known as the “inverted yield curve.” It happened last week, three times actually, and was officially recognized by the U.S. Treasury on Friday. Here’s what you need to know — and what you need to do next.

Bond-Market Basics

Before we drill down here, there are a few foundational things you need to understand about the U.S. government bond market. U.S. Treasury notes – issued when Washington needs to borrow money – are viewed as the lowest-risk investments around, since the backing of the American government makes the default risk very low.

That makes them popular investments during periods of uncertainty. And with all the uncertainty investors face right now, it’s no surprise that investor interest in Treasuries has been supercharged.

And because bond yields move opposite bond prices, that revved-up interest has had an impact on Treasury prices and yields.

As investor cash floods into Treasuries, prices zoom and yields drop.

In more predictable periods, longer-term Treasuries like the 10-year have higher yields than their shorter-term (two-year) counterparts – since investors demand a bigger interest rate for that longer commitment.

When that relationship “inverts” – flips – it’s a sign that investors are less optimistic about the near term than they are about the long haul. They expect near-term rates to drop – most likely because of worries about the health of the economy.

And that inversion is what we saw last week.

A year ago, long-term rates were nearly 1.5 percentage points higher than short-term rates.

Then, last week, the 10-year U.S. Treasury yield dropped to 2.383% while its two-year counterpart rose to 2.387%.

Because the two-year and 10-year Treasuries are among the most commonly traded, their inversion is often considered the bellwether for a future recession. In fact, an inversion in these two yields has correctly predicted – within eight months to two years – each of the last eight recessions.

Last week’s inversion was the first since August 2019.

As I’ve shown, it’s a fairly reliable indicator, and that should concern you. It concerns me when we see a recession because it leads to:

• Big surges in joblessness
• Squeezed corporate earnings
• Loan defaults and bankruptcies at the corporate level
• Surging foreclosures in the housing market
• Stumbles among debt-logged consumers

Ordinarily, the U.S. Federal Reserve could mitigate the effects of an inversion by lowering rates. That tends to stimulate economic growth and move us further from recession. But as we heard recently from Fed Chair Jerome Powell, central bank policymakers are focused on stopping inflation before it hits double digits.

Powell has already signaled that the board is leaning toward a May increase of 50 basis points in the benchmark federal funds rate. In fact, since higher rates tend to dampen the economy, the Fed may actually be hastening the inversion and quickening the pace toward recession.

But Team Powell’s hands are tied.

Before I continue, let’s take a side trip to define exactly what a recession is and how it could impact all of us.

What You Need to Know about Recessions

According to the National Bureau of Economic Research (NBER), the group that gives downturns their official status, a recession is a period of declining economic performance across the market, lasting several months. It’s generally punctuated by reductions in gross domestic product (GDP), jobs, industrial production, and wholesale and retail sales.

Previously, to count as a recession, these reductions had to occur for at least two consecutive quarters, but the NBER has shortened that requirement to only a few months.

We could be watching this play out in real time, as sanctions against Russian oil are causing prices to spike domestically – creating the kind of surges in gasoline, diesel fuel, and general energy that can smother economic growth.

In an interview last week, Moody’s Analytics Chief Economist Mark Zandi said that there’s “at least” a one-in-three chance the U.S. economy will have a recession over the next 12 months.

As bad as all that sounds, some caveats are necessary.

First, while a yield curve inversion is ominous, the impact isn’t immediate.

In fact, going back to recessions from the 1970s forward, the average length of time between yield curve inversion and the actual start of a recession was 627 days.

Second, recessions seldom last that long: Since World War II, the average duration has been only 11 months.

And third, as former U.S. Secretary of Labor Robert Reich said in December 2020: “Repeat after me: The stock market isn’t the economy.”

In a research note to clients on March 24, Invesco Global Markets Strategist Brian Levitt wrote that yield curve inversion has proved to be a lousy timing tool for trading stocks.

“For example, investors who sold when the yield curve first inverted on Dec. 14, 1988, missed a subsequent 34% gain in the S&P 500 index,” Levitt wrote. “Those who sold when it happened again on May 26, 1998, missed out on 39% additional upside to the market. In fact, the median return of the S&P 500 index from the date in each cycle when the yield curve inverts to the market peak is 19%.”

Moreover, there are areas of the market that historically do well during recessionary periods.

The bottom line: The yield curve inversion isn’t a trigger for panic; it’s a signal – one that gives you plenty of time to position yourself and your portfolio accordingly. In that spirit, I dug into our tools here at TradeSmith to give you three moves to consider right now.

Yield-Curve-Inversion Play No. 1

The top-performing S&P sector after an inversion is utilities. No surprise there: Utilities are a defensive play, and history says that if you bought a utilities investment one day prior to a yield curve inversion and sold six months later, your average return would be 8.59%.

That’s nearly three and a half times better than either the two-year or 10-year bond, and you only have to hold it for six months.

It’s one of the few recession-proof plays. Demand for electricity and gas doesn’t go away, for consumers or for businesses.

Also, investors favor the utilities sector during recessions because of higher dividend payments and steady cash flow.

A search of the TradeSmith S&P Sectors reveals plenty of options, but one of special interest is an ETF called the Utilities Select Sector SPDR Fund (XLU).

XLU entered the Health Indicator Green Zone on July 27, 2020, after a brief detour into Red Zone stop-loss territory. The ETF has advanced 29% since its entry signal.

XLU has a Volatility Quotient (VQ) of 16.07% and is in an upward trend – always a good sign.

Yield-Curve-Inversion Play No. 2

One stock in the utilities sector that excites me is Sempra Energy (SRE). It posted strong results in its fiscal year 2021 fourth quarter, with reported earnings of $604 million, an increase of more than 45% over Q4 2020.

SRE entered the Green Zone on Dec. 17, 2020, at $126.45 a share. It soldiered along solidly in a side-trend until March 8, when it launched into an upward trek, growing 28% to $162.46.

With a VQ of 20.32%, there’s a medium risk associated with this stock. SRE has qualified for four of our Ideas Lab strategies, and the stock appears in the portfolios of two billionaires we track in the Billionaires Club.

Yield-Curve-Inversion Play No. 3

For our last “inversion play,” I’m looking at the consumer staples sector – one that has historically done well during recessionary stretches. The stock that has my attention here is Coca-Cola Co. (KO).

For the fiscal year 2021 fourth quarter, Coca-Cola posted net revenue of $9.46 billion, an increase of 10% for the quarter – and a result that trounced Wall Street forecasts of $8.96 billion.

It’s a popular stock, and you may already hold a position in your portfolio. But if you’re considering unloading it in anticipation of market declines in a recession, now may be an inopportune time.

KO entered the Green Zone on Aug. 3, 2020, at $43.84 a share. It has briefly dipped into the Yellow Zone only twice and achieved a high of $62.37 on Feb. 25, soaring 42% since its August Entry Signal.

Currently trending sideways, KO has a medium risk VQ of 17.66% and meets the criteria for four Ideas Lab strategies, one of which is Dividend Growers, so it’s an income stock. It’s tracked in four newsletters and featured in the portfolios of two investors in the Billionaires Club.

What to Watch for

The takeaway here is simple. Only time will tell if the yield curve inversion is signaling a recession. But the one thing you don’t want to do is panic.

The lag between the signal and the outcome can be substantial, but unpleasant surprises are possible too.

You can count on TradeSmith to continue monitoring the markets and economy closely. We’ll publish our findings right here in TradeSmith Daily so you have the information you need to make better, more profitable financial decisions for your future.

So tell me what you think. Email me your thoughts on the yield curve inversion. Is it as scary as some think, or is it just another market cycle we’ve weathered time and time again?