JM investor wrote a post · Apr 6, 2022 12:31

Inverted Yield Curve | What to do with recession and the stock market?

Thank you MooMoo community to vote for my moment, and yield curve is getting No.1!
As promised, I am going to prepare videos for yield curve and Interest rate. For the unemployment rate, i will also prepare it as it also >10 votes, but it will be later as it is more important to anticipate the bottom in a recession.

Hello everyone! Last video we talked about how to combine 2 bottoming signals to anticipate a bottom. Is there a way to anticipate a market top? Yes! Today, I am going to introduce a macro-indicator: Yield curve. Please make sure to watch until the end, as I will give the most update yield curve, recession and the market update!

Similarly, you are encouraged to watch my video here to understand better the whole concept, as it is animated. If you gain any insight from my video/post, please give me a like on this video, and subscribe my channel by clicking the icon at the bottom right corner of the video to motivate me more :) All videos were prepared with my blood and sweat, so your like and subscribe are indeed will encourage me to provide quality free content consistently :)

You may click this button at the bottom right of the video to subscribe my channel :)

Inverted Yield Curve | What to do with recession and the stock market?

From YouTube

First, we need to understand the relationship between yield curve, recession and stock market.

Let us start with recession first.

Since year 1980, there are 6 recessions in the US:

Year 1980 recession from Jan to July 1980

Year 1981-1982 recession from July 1981 to Nov 1982

Early 1990 recession from July 1990 to Mar 1991

Early 2000s recession from Mar 2001 to Nov 2001

Great recession from Dec 2007 to Jun 2009

The most recent one Covid-19 recession, from Feb 2020 to April 2020.

Ok, so what is recession? The most popular, and the easiest to understand was two consecutive quarters of declining GDP.

History shows us that recessions have occurred for many reasons but typically are the result of imbalances built up in the economy that need to be corrected. These include rising interest rates, inflation and commodity prices as well as anything that hurts corporate profits which may trigger higher unemployment.

Then, how stock market responses with recession?

In fact, 5 out of the 6 recessions since year 1980 fall into bear territory!

Stock prices are influenced by many factors. One key issue is the strength or weakness of the underlying economy. When the economy is strong, consumer and business spending increases and corporate profits improve. Greater profits support higher stock prices. Conversely, when economic activity slows, spending declines, profits are reduced, and stock prices fall. The stock market typically continues to decline sharply for several months during a recession.

Ok, so now we know during recession, stock market most likely will be going down, and high chance that it will fall into the bear territory!

Next, let us look on the relationship between yield curve and recession.

Understand bond and yield

But before that, we need to understand the term “bond”, in this context, we will be focusing on Treasury bonds, which are government debt securities issued by the U.S. Federal government that have maturities of different terms. When we buy the Treasury bond, we are lending our money to the government, we will be paid a specified rate of interest during the life of the bond, and will be repaid the principal sum when the bond matures.

Bond prices are inversely translated to the rate of interest, or yields. When the demand of a bond is high or many buyers, prices of the bond rise, yields then drop. By contrast, when many sellers are selling the bond, prices of the bond drop, yields then rise.

How about the maturity period of the bond and yield? If you to buy a 2-year bond or 10-year bond, which one do you think will give you higher yield? Of course, since I park my money longer, I should expect a higher yield right? Therefore, 10-year bond should yield more than 2-year bond!

If we plot the yield of 2-y, 5-y, 10-y and 20-y bonds, we will get this graph. This is called “Yield Curve”. We can see that in general, longer term bond brings us higher yield.

Let us see a typical normal bond table

On 01 of Mar 2022, yield of 2-yr treasury bond is 0.78%, and the yield of 10-yr treasury bond is 1.63%! The different of 0.78% and 1.63%, in this case, is 0.85%, is called yield spread.

Why bond yield is important?

Bond market is able to tell us valuable insight into the risk appetite of the market. In general, in a risk-on environment, investors are greedy and investors tend to sell bonds in favour for better returns in the risk market, such as stock market. Money flows from bond market to stock market. Bond prices therefor drop, raising yields, and stock market rally. In addition, during a risk on environment, investors generally use short-term bonds as hedges against their positions in the risk market. This causes short-term bonds will not be sold as much, or may even be bought up as an additional hedge. Therefore, the yield of short term bond, normally does not increase a lot, or even decreases in a bull market. The yield curve is mostly steep in this period. A steeping yield curve represents long-term greed in the risk market.

In contrast, if the risk market continues to rally and break new highs again and again, doubt will creep in on the sustainability of the rally. Investors or big institutes start to take their profits, and then look for a safer but higher return, for example long-term bond to park their money. The market is starting to turn into risk-off environment. Money flows from risk market, such as stock market, to the bond market. In addition, when the short-term bond is maturing, investors may reinvesting into long term bonds which yields better return. Consequently, prices of long term bonds will rise, and yields fall, while prices of short term bond will fall, causing their yields to rise. This will narrow the spread, and the yield curve is flattening. A flattening yield curve signifies medium term doubt.

However, what if the investors are feeling huge uncertainties or fear? The above process will be accelerated: Investors buy a lot more long term bonds, push the price even higher, or pull the yield even lower, causing long term yields to below the short term yield! This resulted in an inverted yield curve, which is a sign of weakening economy and possible recession. Inverted yield curve is a signal of extreme fear in the risk market! Also take note that, normally investors weight more on the 2-y and 10-y yield.

The summary is shown here:When the risk market recovers, long-term bonds will be sold off, sending prices down and yields up. Short-term bonds will also be bought as hedges for profitable positions to the risk market, causing prices to rise and yields to fall. The yield curve is in the process of “normalization”.

Next, let us see different scenarios on how a yield curve may be flattening or inverting. Each method of flattening signifies a different level of doubt and fear.

i) Pivot on the middle: The short-term yields rise while the long-term yields fall. This is the earlier example of the flattening curve that I have described above.

The summary is shown here:

i) Pivot on the back: The short term yields rise, while the long term yields hold. When this happens, it signifies a drastically short-term bonds are drastically sold off. This represents the investors sell off their risk market investments and short-term bonds to seek safer avenues of income, such as cash.

ii) Pivot on the front: The short term yield holds, while the long term yields fall. This happens when investors rush huge sums of money into the long-term bond, sending prices up and yields down. This represents a huge amount of long term fear in the risk market.

Yield curve and recession:

The history told us that when the yield on 10-year treasury bonds dips below the yield for 2-year bonds, a recession has followed!

Thus, this conclude the loop:
Inverted yield curve – Recession – market dip or crash

It is definitely not a good sign when the yield curve is inverted.

So, now what happen to the today market?
On 31Mar, the 2-year treasury yield tops 10-year rate again. Yield curve is inverted.

Yield of 2-y treasury bond is 2.462%, while 10-y treasury bond is 2.39%.

Let me plot the yield curve on the first day of January, February, March and April 2022.

These are the observations:

1. We can see that the yield of 2-years Treasury bond rises significantly compared to the 10-year yield. This is pivoting on the back.

2. However, do you notice that, in fact, all the bonds are being sold since January 2022? Because the yields are in general increases for all bonds across 2-20 years maturity. If the bonds are sold, should it considered as risk on? Then why we just suffered a recent dip correction since January this year? Where does the money go?

3. The main reason is the issue of inflation. Inflation is a bond's worst enemy. Inflation erodes the purchasing power of a bond's future cash flows. Typically, bonds are fixed-rate investments. If inflation is increasing (or rising prices), the return on a bond is reduced in real terms, meaning adjusted for inflation. For example, if a bond pays a 2.5% yield and inflation is 2%, the bond's real rate of return is 0.5%!

And we know that the current inflation is higher and higher. Supply chain issue, Ukraine-Russia war, pandemic, surge of oil price, sanctions on Russia and the counter-sanctions…. All of these contribute to the inflation. Investors are fearing of the inflation will erode all the yields of the short term bond, and thus they are selling crazily and push the yield higher and higher.

Thus, with the rising of inflation, bond is no longer attractive and therefore investors are selling them!

Then, where does the money go? Money goes into cash, which is also considered as a safe heaven.From this chart, on 14Mar2022, $Powershares Exchange Traded Fd Tst Db Us Dollar Index Bullish Fund Etf (UUP.US)$ , one of the long U.S. Dollar ETFs, is showing a positive growth of 3.28% since January. The 10-years Treasury bond etf, $iShares 7-10 Year Treasury Bond ETF (IEF.US)$ , suffered a -5.12% decline. Stock markets, both $S&P 500 Index (.SPX.US)$ and $Nasdaq Composite Index (.IXIC.US)$ , showing a decline of 4.62% and 17.63% respectively.

Conclusion? Based on my research, the investors are fearful that the inflation will be out of control, and therefore selling the short term bond tremendously, push the yield high enough to invert the yield curve. However, the investors are also doubt on the risky market, as they park their money on USD.

If core inflation remains high and inflation expectations rise, the Fed could be left with no choice but to quickly move rates to neutral or restrictive levels. A more abrupt adjustment path could take a big toll on GDP including through tighter credit conditions and a sharp rise in long-term US bond yields. Which will then lead to recession.

CNBC Fed Survey shows that the probability of recession next 12 months is 33%!

And from the initial part of this video, recessions most likely will hit the market badly, and high chance of enter a bear market. What should we do? Oh well, hopefully this video could give you some insights and basic knowledge on the yield curve. I will share my strategy to protect myself if the recession is coming. Please remember to subscribe my channel, and turn on the notification bell so you won't miss my strategy video. Thank you and see you in the next video.

Disclaimer: Community is offered by Moomoo Technologies Inc. and is for educational purposes only. Read more

Translate

Report

214K Views

Comment

Milk The Cow : I already just learn it on my own.
I think I knows what I'm doing already (usually ppls who claims they know what they are doing = Not )

I will still see video to see if there are more new pointers .

Report
Reply

Cancel Reply
Milk The Cow : As usual, ur cartoon look nice , I means picture illustration .

Looking forward to see ur strategies.

Report
Reply

Cancel Reply
JM investor OP Milk The Cow : haha thank you! all from software I just put them together

Report
Reply

Cancel Reply
48685 : thanks for sharing

Report
Reply

Cancel Reply
JM investor OP 48685 : thank you!

Report
Reply

Cancel Reply
Milk The Cow JM investor OP : What software is that ?
Can make such cool thing?

Report
Reply

Cancel Reply
icezzz : Nice video. Thanks

Report
Reply

Cancel Reply
JM investor OP Milk The Cow : I used doodly. last time they had promotion I bought their basic lifetime license for around USD50 .
they have one more premium license but that costs a lot more haha.

some graphics I use canva and we can use it for free

Report
Reply

Cancel Reply
JM investor OP icezzz : thank you so much!

Report
Reply

Cancel Reply
Milk The Cow JM investor OP : I see.

Report
Reply

Cancel Reply

View more comments...

JM investor

learn investing in my YouTube channel at "JM investment journal"

6616Followers

25Following

4680Visitors