The focus on inverted yield curves has been on the signal it provides about future recessions, but it is more important to look at how investors will change their behavior given the inversion. It is the behavior that will impact market prices and capital flows and right now it pays to raise cash levels.
If there is an expected slowdown in economy which will led to lower rates, then worth taking duration risk but not equity risk. If there is no slowdown, investors may prefer equity risk over fixed income duration risk. If investors are uncertain and risk averse, then their preferences may be with increasing cash at the current low opportunity cost. At the least, increasing cash levels will lower risk but will actually increase current yield. Simply put, every percent decrease in a risky 60/40 stock/bond (SPY/IEF) portfolio will lower portfolio risk but actually increase stand-alone return. This is not a difficult trade if you don't have a strong positive view on stocks or bonds.
If each investor increases the cash portion of their portfolio, in aggregate, there will be a significant decline in demand for risky assets. Prices will have to fall to clear the market. The earlier asset price fears are realized. Of course, cash rates will also fall or the Fed will engineer a decline that will eventual take us back to an upward sloping curve, but that will occur sometime in the future.
- Current short rates (3-month Treasury bills) are greater than the dividend yield on S & P 500; (2.24% vs 2%)
- Current short rates (3-month Treasury bills) are greater than 10-year Treasury bonds; (2.34% vs 2.15%)
- Holding cash better than stand alone equity risk assuming zero capital appreciation.
- Holding cash better than taking on duration risk assuming current yield and no movement in rates.
If there is an expected slowdown in economy which will led to lower rates, then worth taking duration risk but not equity risk. If there is no slowdown, investors may prefer equity risk over fixed income duration risk. If investors are uncertain and risk averse, then their preferences may be with increasing cash at the current low opportunity cost. At the least, increasing cash levels will lower risk but will actually increase current yield. Simply put, every percent decrease in a risky 60/40 stock/bond (SPY/IEF) portfolio will lower portfolio risk but actually increase stand-alone return. This is not a difficult trade if you don't have a strong positive view on stocks or bonds.
If each investor increases the cash portion of their portfolio, in aggregate, there will be a significant decline in demand for risky assets. Prices will have to fall to clear the market. The earlier asset price fears are realized. Of course, cash rates will also fall or the Fed will engineer a decline that will eventual take us back to an upward sloping curve, but that will occur sometime in the future.
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