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Optimizing Portfolio Strategy for the Inversion Cycle: Buy 10-Year Treasuries and Sell S&P 500 in Q1 2024

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As an investor or trader, understanding the dynamics of the inversion cycle and its implications can greatly inform your portfolio strategy. By analyzing the historical patterns of yield curve inversions, we can project potential outcomes for market prices and the economy. In this article, we will delve into the inversion cycle, market and economic projections, and develop a trading setup based on these insights.

Inversion Cycle: Decoding Historical Patterns

The inversion of the 10-year and 3-month U.S. Treasury yields has occurred nine times since 1955, with the latest inversion observed in November 2022. This phenomenon has proven to be a reliable indicator of impending economic and financial downturns. By understanding the inversion cycle, investors can position themselves to navigate the coming period effectively.

Based on historical data, we have identified key patterns in the inversion cycle:

  • The equity markets tend to start falling four months prior to the inversion and bottom out 31 months after.
  • The 10-year yield experiences a sharp rise for 24 months before the inversion, followed by a slight decline until eight months after. The peak in the 10-year yield occurs three months after the inversion.
  • The FED Funds rate also rises sharply before the curve inverts, reaching its peak 14 months after the inversion. It then starts to decline and tests previous levels six months prior to the inversion.
  • Real economic growth starts slowing four months before the inversion and continues to decelerate until 28 months after, eventually bottoming out 6% lower compared to the inversion point.

Itโ€™s important to note that deceleration does not necessarily mean contraction. Negative growth is typically observed from the 18th month to the 31st month after the inversion.

Market & Economic Projections: Insights for Portfolio Strategy

Based on the historical patterns of the inversion cycle, we can project the future market and economic conditions. In 2024 Q2, we anticipate a sharp decline in cyclical economic growth, FED rates, and the 10-year yield. This projection aligns with the 16th and 17th months after the November 2022 inversion.

If the current inversion cycle turns out to be deflationary, it is less likely that the FED will readjust rates higher due to the upcoming debt maturities and refinancing period from 2024 to 2027. However, if inflation becomes structural and re-accelerates, the FED may be compelled to raise rates again.

According to our projections, the 10-year yield is expected to test levels seen nine months prior to the inversion by the 19th month after, placing it below 2% by July 2024. In the same period, FED Funds rate should fall to 1.5%.

The SP500 has already been pricing in longer-term rate projections since the end of 2021. As the 10-year yield rose in 2022, the markets experienced a sell-off. However, as the yield stabilized around the 3.5-4% range, the SP500 started to recover. Since the end of July, the 10-year yield has broken out upwards from its 4% range, reaching 5%. This upward move in longer-term yields has contributed to the ongoing correction in the SP500 since July. We can expect the yield to decline back to the previous range top of 4% in the next two months.

If longer-term yields indeed decline as projected, it would support the SP500 to retest the July 2023 highs or even reach all-time highs by the end of the year. However, if geopolitical risks, such as an escalation in the current Middle East crisis, intensify, the SP500 could start falling earlier, even with declining yields.

As the economy enters contraction in the 17th month, the equity market is likely to experience a regime shift. The primary focus will shift to the earnings outlook, and rising defaults and risk aversion can be expected. Itโ€™s essential to note that the rebound in the Fed tightening due to structural inflation weakens the equity market during the second tightening phase after the initial rebound.

On average, the SP500 bottoms out 32 months after the inversion, reaching levels seen 24 months prior. This projection suggests that the SP500 could decline to November 2020 levels of around 3,250 by July 2025. However, if the current cycle turns out to be deflationary, the FED may not engage in a second hiking cycle, potentially resulting in an earlier bottoming out for the SP500. Conversely, if inflation remains a structural concern, the FED may need to hike rates again, delaying the weakness in equity markets.

Itโ€™s also worth monitoring the governmentโ€™s response to the next significant downturn. If they provide extensive support to the system, it could push deficits and debt to problematic levels, eventually leading the market to start pricing credit risk. This could cause the 10-year yield to reverse sharply, even without structural inflation.

Portfolio Strategy & Trading Setup

Based on the market and economic projections, we suggest the following portfolio allocation:

  • October 2023 โ€“ Year End 2023: Long 10-year T-Note, Long SP500
  • January 2024 โ€“ March 2024: Short 10-year T-Note, Short SP500
  • April 2024 โ€“ June 2024: Long 10-year T-Note, Short SP500
  • July 2024 โ€“ July 2025: Short 10-year T-Note, Short SP500

The most significant returns are expected from the long position in the 10-year treasury from March 2024 to July 2024, and the short position on the SP500 from January 2024 to July 2025.

However, itโ€™s crucial to adjust the portfolio strategy to account for possible outcomes of inflation/deflation and geopolitical developments. These factors can significantly influence the current cycle compared to historical averages. Additionally, consider the U.S. governmentโ€™s debt and deficit conditions after their response to the next downturn, as well as the mass debt maturity and refinancing wall from 2024 to 2027.

Note: The projections and portfolio strategy outlined above are based on historical data and patterns. However, market conditions are subject to change, and investors should continuously monitor economic indicators and adjust their strategies accordingly.

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