Tuesday, March 12, 2013

How to Profit from an Inverted Yield Curve?

In normal market conditions a yield curve will slope upwards from left to right as shown by Chart 1 below. This is because the short term interest rate is higher than the long term interest rate. The reason for the upward slope is that investors will always seek a higher return on their capital in the long term because they are exposed to higher risk of default and counter party risk. Also their funds are tied to the investment and hence denied it of any opportunity that arises along the way. This is why short term ( 2 years or less) interest bearing investment tools such as bond pays a lower interest rates than longer term bonds.

Chart 1

However during certain times the yield curve can be inverted. The reason for the yield curve being inverted is because the short term interest rate is higher than the long term interest rate. As shown in Chart 2 below the interest rate for a 6 month might be trading at 18% while the 3 year bond fetches 16%. Why is this so? One of the main reasons is that the Central Bank believed that the economy may be over heating and hence by raising the short term interest rate it hoped to slow down the economy. Or in other words it hope to cool down the economy so that it will have a ‘soft landing’ in future.

Chart 2

What effects will an increase in the short term interest rate on the economy and stock market? One thing for sure is that it will make the short term borrowing more expensive and hence will deter people from borrowing funds. The following are the effects on both the corporations and individuals.

  1. Corporations will find it too costly to borrow funds to finance any new projects such as building new plants or expansion of existing plants and hence will delay or even shelve them for the moment. On top of this corporations will also need to allocate more funds to pay for the higher cost for their existing loans. Hence this will have the effect of lowering their profits and hence will later translate to lower stock prices.

  1. As for the individuals, they too find it difficult to contemplate on the higher cost of funds. They too will delay their purchases on big ticket items such as cars and houses. This is because they find that purchasing such items with credit may be too expensive and hence either be curtailed or shelved completely. When consumers cut back on their purchases it will also affect the bottom line of corporations that produces them. When corporations failed to meet earnings estimates then naturally their share price will get hammered.

So when the Central Bank announces an increase in the interest rate then it signals that it is going for a Contractionary Monetary Policy. We as investors should take heed on such moves because in future there will be a slowdown in economic activity and will not be good for the performance of corporations. Continuous tightening by the Central Bank will have the effect of pushing the economy towards recession and hence might cause a bear market in stocks. One of the first logical things to do is to lighten up on your portfolio.

In summary, when the yield curve move towards inversion then we should gradually lighten up our portfolio and hold on to more cash because at the later stage ‘cash will be king’. Moreover when interest rates are high other forms of investment such as term deposits and bonds will be more attractive and hence more funds will be flowing out of the stock market. The end result will be a softer stock market. So what we should do is to move our cash into term deposits or the money market while the market is still soft. When the authorities felt that the economy needs a boost it will need to reduce the short term interest and hence the yield curve will revert back to normal. When interest rates are low, stocks (especially interest rate sensitive stocks such as utilities, banks, telecommunication and construction) will rebound. So we reckoned that when the yield curve is inverted, it will only be a temporary effect because it will have to revert back to normal sooner or later and hence offers an opportunity to buy interest rate sensitive stocks at a discount.

However in order to capitalize on such a move you are require to stick to the 'buy and hold' strategy preferably for at least 1 year. This is because Central Bank interest reductions will have a 'lagged effect' of at least 3-6 months for it to work its way into the economy.

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