- Prior to recession the yield curve becomes inverted, as indicated by the Forward Rate Ratio between the 2-year and 10-year U.S. Treasury yields (FRR2-10) being less than 1.00.
- Currently the FRR2-10 is 0.998 and the smoothed FRR2-10 is 1.016 signifying that US economic activity is near the end of the expansion phase of this business cycle.
- When FRR2-10 falls to near 1.00 the transition from expansion to boom occurs, as during boom times the Federal Funds Rate (FFR) is increased to slow the economy.
- After the boom period comes the recession, on average 14 months after the FRR2-10 becomes less than 1.00, and concurrently the FFR is lowered.
- An almost risk-free investment is to buy 2-year Treasury bonds when the FRR2-10 is close to 1.0 and to sell when the FFR is at its lowest after recessions.
It is well known that an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality is considered to be a predictor of recessions. It is reasonable to assume that a similar pattern will prevail in advance of future contractions of the economy.
This model uses the 2-year and 10-year U.S. Treasury yields as measures of short-term and long-term rates, respectively, and calculates the Forward Rate Ratio (FRR2-10) between the two rates. (For the formula see the Appendix in the linked article.) An upward positive slope of the graphed FFR2-10 indicates a widening spread between the two rates, and a downward negative slope indicates the opposite.
FRR2-10 is the rate at which one can lock in borrowing for the eight year period starting two years from now, divided by the ten-year rate itself. A FRR2-10 greater than 1.00 indicates a yield curve with ten-year note yields higher than two-year note yields; a FRR2-10 less than 1.00 indicates an inversion of the yield curve when two-year note yields are higher than ten-year note yields.
In Figure-1 the smoothed FRR2-10 and Federal Funds Rate are shown. One can see that the yield curve was inverted prior to the last seven recessions (the grey shaded areas in the chart). Currently (end of August 2019) the yield curve is inverted again, indicating that we are near the boom phase of the business cycle, not far away from the next recession, diagrammatically shown in Figure-2.
Also, one observes that the Federal Funds Rate is near a high when the yield curve inverts and then begins to fall before, during, and after recessions for some time. Currently the FFR has formed a peak, and our expectation is that it will drift lower as it did in the past. Also, usually when the FFR forms a trough the FRR2-10 peaks.
The proposed investment is the U.S. 2 Year Treasury Note bond or the iShares 1-3 Year Treasury Bond ETF (SHY) which has an Effective Duration of 1.85 years.
The fixed income investment is made when the Forward Rate Ratio between the 2- and 10-year yields becomes less than 1.00, and it is sold when the Federal Fund Rate has reached a low after a recession. In Figure-1 the buy- and sell signals are indicated by the green and red arrows, respectively.
Table-1 shows the beginning and end dates of the investments for the past seven “recessionary epochs”. The strategy always returned a profit, with annualized returns ranging from 5.9% to 15.8% over those periods. There were only two occasions when an investment in the S&P 500 with dividends would have had somewhat higher returns.
For the most recent two “recessionary epochs” the relative performance of SHY and the S&P500 ETF (SPY) is shown in Figures-3 and -4 in the Appendix. Note the maximum drawdowns of about -50% for SPY, versus about -2% for SHY.
Also, for verification purposes actual returns of SHY for various periods are compared with returns calculated from the 2-year bond yields, Table-2 in the Appendix refers.
From the analysis it appears that relatively risk-free satisfactory returns can be had by investing in 2-yr Treasury bond funds prior to recessions when the yield curve inverts, and holding the investment until after recessions when the Federal Reserve is done with lowering the Federal Funds Rate.