The Alpha Team How to Construct a Global Portfolio After a Yield Curve Inversion

Yield Curve Professor Campbell Harvey developed a widely used measure called the yield curve to predict US Recessions Professor Campbell Harvey developed a widely used measure called the yield curve to predict US Recessions Yield curve is the difference between long-term and short term interest rates Yield curve is the difference between long-term and short term interest rates With an inversion short-term rates are greater than long-term rates indicating a shift in investors expectations With an inversion short-term rates are greater than long-term rates indicating a shift in investors expectations

Industry Standard Measures of Yield Curve

Goals We wanted to investigate the international capacity of the yield curve measures. We wanted to investigate the international capacity of the yield curve measures. First we wanted to see if the inversion of the yield curve predicted recessions in countries that are highly correlated with the US First we wanted to see if the inversion of the yield curve predicted recessions in countries that are highly correlated with the US If so is there a consistent relationship between lag lengths? If so is there a consistent relationship between lag lengths? Secondly, does the inversion of the US yield curve indicate an inversion of the local yield curve measure? Secondly, does the inversion of the US yield curve indicate an inversion of the local yield curve measure? Finally, does the yield curve inversion for local yields or for the US yield curve provide us with a simple profitable trading strategy for these countries? Finally, does the yield curve inversion for local yields or for the US yield curve provide us with a simple profitable trading strategy for these countries?

Is the US Yield Curve predictive for recessions in foreign countries? The US yield curve has had much success in predicting US recessions, but does it also predict recessionary periods in the countries that are highly correlated with the US? The US yield curve has had much success in predicting US recessions, but does it also predict recessionary periods in the countries that are highly correlated with the US? To answer this question we first gathered data from the ten most heavily trading countries with the US To answer this question we first gathered data from the ten most heavily trading countries with the US Canada, Mexico, Japan, China, Great Britain, Germany, France, South Korea, Taiwan, and Australia Canada, Mexico, Japan, China, Great Britain, Germany, France, South Korea, Taiwan, and Australia Then looked for possible correlations between the US yield curve inversion with a possible recession in the foreign countries Then looked for possible correlations between the US yield curve inversion with a possible recession in the foreign countries

Trade Balances Over Time How the trade between the US and these countries changes over time is important when analyzing the impact of the yield curve measure How the trade between the US and these countries changes over time is important when analyzing the impact of the yield curve measure The expectation is that as trade increases the impact of the yield curve also increases The expectation is that as trade increases the impact of the yield curve also increases

GDP and US Yield Curve Is the US yield curve a predictor for foreign recessions? Is the US yield curve a predictor for foreign recessions?

Country Specific Yield Curves The impact of the yield curve on GDP for foreign countries does not appear to be significant The impact of the yield curve on GDP for foreign countries does not appear to be significant The impact did not grow with trade (this result is further vindicated in our regression analysis) The impact did not grow with trade (this result is further vindicated in our regression analysis) Does an inversion in the US yield curve indicate inversion of country specific yield curves? Does an inversion in the US yield curve indicate inversion of country specific yield curves?

GDP and Yield As shown above an inversion in the US yield curve could be an indication that countries such as Canada might also suffer a yield curve inversion As shown above an inversion in the US yield curve could be an indication that countries such as Canada might also suffer a yield curve inversion Does the inversion of a country specific yield curve act as a reliable measure for recessionary periods? Does the inversion of a country specific yield curve act as a reliable measure for recessionary periods?

Local Yield Curve Inversions and GDP UK

Local Yield Curve Inversions and GDP Germany

Local Yield Curve Inversions and GDP Canada

Local Yield Curve The local yield curve measures do not appear to be dependable predictors of local recessionary periods in GDP The local yield curve measures do not appear to be dependable predictors of local recessionary periods in GDP Further statistical tests should be preformed Further statistical tests should be preformed

Yield Curve and Equity Markets Due to the fact that the US yield curve had little predictive power as to foreign recessions we turned our attention to the equity markets Due to the fact that the US yield curve had little predictive power as to foreign recessions we turned our attention to the equity markets Does the US yield curve have predictive power for foreign equity returns? Does the US yield curve have predictive power for foreign equity returns?

Yield curve inversion coincides with a negative/depressed average return. Holds for all periods expect September 1998 to December – –Russian Government Default – –LTCM Bailout

Trading Strategy Long position during contango, short position during inversion. Is there a lag between inversion and negative equity return? – –Yes, but built in.

Trading Strategy Extend this strategy to foreign equity. Three Correlation Groups Three Correlation Groups – High –Middle –Low

Average Equity Returns

Trading Strategy Exclude February 1990 to August 1998 and September 1998 to December – –Strategy holds for 97 out of 106 periods. – –91.5%

Trading Strategy Trading strategy as a simple linear regression. – –Equity Return t =  +  *Inversion Dummy t +  *Inversion Dummy t *US5Y-3M t Expect the dummy coefficients to be negative. – –Exceptions (Germany, China, Korea, Mexico, Taiwan

Alternative to L-S Trading Strategy Based on forecasting returns during most recent US yield curve inversion Based on forecasting returns during most recent US yield curve inversion From period of initial inversion forecast future returns of correlated equity markets From period of initial inversion forecast future returns of correlated equity markets Due to missing data, only Australia, Canada, France, Germany, Japan and UK considered Due to missing data, only Australia, Canada, France, Germany, Japan and UK considered

Alternative to L-S Trading Strategy Optimize portfolio weights for period of inversion. Discontinue strategy once period of inversion ends. Optimize portfolio weights for period of inversion. Discontinue strategy once period of inversion ends. Compare returns from optimal trading strategy using forecast values (min of - 20%, max of 50% weighting) with optimal weightings up to beginning of inversion. Compare returns from optimal trading strategy using forecast values (min of - 20%, max of 50% weighting) with optimal weightings up to beginning of inversion.

Alternative to L-S Trading Strategy Using weightings from both strategies, optimize determine returns to both strategies given actual returns for sample period. Using weightings from both strategies, optimize determine returns to both strategies given actual returns for sample period.

Alternative to L-S Trading Strategy Based on forecasting returns during most recent US yield curve inversion Based on forecasting returns during most recent US yield curve inversion From period of initial inversion forecast future returns of correlated equity markets From period of initial inversion forecast future returns of correlated equity markets Due to missing data, only Australia, Canada, France, Germany, Japan and UK considered Due to missing data, only Australia, Canada, France, Germany, Japan and UK considered

Alternative to L-S Trading Strategy Optimize portfolio weights for period of inversion. Discontinue strategy once period of inversion ends. Optimize portfolio weights for period of inversion. Discontinue strategy once period of inversion ends. Compare returns from optimal trading strategy using forecast values (min of - 20%, max of 50% weighting) with optimal weightings up to beginning of inversion. Compare returns from optimal trading strategy using forecast values (min of - 20%, max of 50% weighting) with optimal weightings up to beginning of inversion.

Alternative to L-S Trading Strategy Using weightings from both strategies, optimize determine returns to both strategies given actual returns for sample period. Using weightings from both strategies, optimize determine returns to both strategies given actual returns for sample period.

Results Truncation auscangerjapukfranceTotal weights-11%7%31%35%21%16%100% er sd Expected Return1.24 Variance Standard Deviat ion

Results Prediction auscangerjapukfranceTotal weights er sd Expected Return Variance Standard Devia tion