The dotcom bubble peaked and burst right as the curve inverted. There is zero guarantee that the markets keep going up from here, although history definitely says its quite possible. There is even a risk for a short-term blowoff top during this time period.
On the whole, the best signal for timing the biggest liquidations is when the fed starts to cut rates after an inversion. With that said, I suggest to anybody looking to risk manage around this that they combine multiple indicators to create a “composite” view of sorts. It’s a lot easier to see signals when you can corroborate multiple warning signs as opposed to just looking at one for confirmation.
Another thing worth noting is that there is far more public awareness around the yield curve now than there was previously. So you combine that with the enormous amount of systematic strategies that likely have rules to de-risk after inversion, and we will likely get more of a self fulfilling prophecy now than we got in the past.
Because I keep seeing this mistake being made on here, recessions often are only realized way after the fact from a data perspective, and markets typically draw down significantly before a true recession even is recognized. So quit trying to manage your portfolio risk based on when a recession does or doesn’t start. It’s not relevant here. You want to manage portfolio risk around when you would see the biggest capital losses, not when we officially hit a recession. Here are some things to keep in mind…
- In the GFC, economists didn’t even formally recognize that we were in a recession until December 1 of 2008. Here is an article for reference. Of course, they were able to recognize in retrospect that we started a recession in December 2007, but this was a completely moot point considering that markets had already dropped 52% by the time they formally recognized this fact.
- In the current economic cycle, Italy just entered into a true recession recently, and Germany / France look like they will be following shortly afterward here. Italy already has had a 30% drawdown from peak to trough, Germany had a 25% drawdown, and France is similar. So if you really want to wait until a recession to start de-risking, you would likely be pretty late to the game.
- In the dotcom bubble bursting, we actually saw an extremely mild recession economically, yet the capital losses which started far before the recession were far more severe than the recession in 1990 despite the fact that economically, the 1990 recession was much worse. If you just balanced your risk out shortly after inversion or when rates started being cut, then you would have fared quite well here.
- Remember, yield curve inversion is basically the market betting that the fed will have to start cutting interest rates in the somewhat near future. As a result, the easiest play regardless of whether we do or don’t get a recession is to simply buy treasury bonds. This trade literally has almost never failed, and there are a lot of obvious reasons why this works. When the fed cuts rates, bondholders get paid… simply put.
- Equity prices often do go up during the period of inversion, at least for a brief period of time. Certain sectors tend to outperform during this time, but there are no guarantees of course. Regardless, if you want to short the market from here, it would be historically accurate to say that there will be a lot of volatility up and down, although on a long-term basis, you would likely be profitable. But the time range is tough to properly gauge of course.
- Anecdotally, I observe in the recent recessions that there are some interesting flows from economies, leading to bubbles forming in whatever is deemed as the best performing economies or assets. I believe this is partially why we got a blowoff top around the dotcom bust as USA’s econ was on fire then, whereas the rest of the world was performing poorly. This phenomenon occurred in the great depression as well. In the GFC, it was reversed, where the USA economy was dragging (similar to Europe right now) and emerging markets got a blowoff phase as money piled away from the US economy into emerging markets, before crashing even worse.