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Markets have been throwing a bit of a tantrum in the last few weeks, with most pundits pointing towards geopolitical volatility and the inverted yield curve as the primary sources of angst.

We typically try to avoid ascribing reason to the daily gyrations of chaotic systems, but it is hard to completely ignore the potential impact of news on market participants.  After all, if we're behaving rationally, we should be adjusting prices to reflect changing outlooks.

That said, signals like "inverted yield curves" are not necessarily as straight forward as they would initially seem.

First, there is the very nature of the yield curve itself: it's a complicated beast.  It is impacted by monetary policy, inflation expectations, economic growth expectations, and supply/demand imbalances.  With all these inputs, trying to figure out precisely what the yield curve is saying about market views at a given time is not necessarily very easy.

Furthermore, we should also consider that markets are reflexive by nature.  If everybody knows that the inverted yield curve signal has historically implied a recession in the next 12-15 months, should we necessarily expect it to work going forward?  

Or, if everybody knows, should we expect it to impact markets faster?

We don't have all the answers, but Eugene Fama and Kenneth French are out with a new paper (link below) arguing that inverted yield curves don't really forecast anything about stock / bond returns.  Definitely worth browsing for a counter-narrative to what we typically hear.

In our own research, we have been exploring macro-based signals and sector trades.  This week, we explore a research note originally published in 2009 that tests the relationship between manufacturing PMI changes and the return of Cyclical vs Defensive sectors.  

With the original research only covering the 1999-2009 period, we extend the results out-of-sample, both pre- and post inception date.  Spoiler: it doesn't work.  (PDF)


⚡️Corey


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Read of the Week
→ BECAUSE I WAS INVERTED: "Inverted yield curves, with higher yields on short-term government bonds, tend to forecast future recessions. Perhaps because of this relation, some investors, fearing that an inverted yield curve predicts low stock returns, reduce their equity exposure when the term spread is negative. We test whether the fear is justified. The answer is no. We find no evidence that inverted yield curves predict stocks will underperform Treasury bills for forecast periods of one, two, three, and five years."  Inverted Yield Curves and Expected Stock Returns



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