Inverted Yield Curve Trading Strategy (Backtest Of Yield Inversion)

The yield of Treasury bonds is often used as a signal for the growth prospects of the US economy. An inverted yield curve signifies a change in investors’ risk appetite. With a yield inversion strategy, traders use Treasury futures to design a variety of trades that can serve both risk management and yield enhancement purposes. Do you want to know more about the inverted yield curve and the Inverted Yield Curve Trading Strategy? Do you want to know how to trade an inverted yield curve?

A yield inversion strategy looks at the inversion of the yield and might indicate a possible recession is ahead of us. The yield curve is a graphical representation of the relationship between the interest rate paid by an asset and the time to maturity, and an inverted yield curve shows that long-term interest rates are less than short-term interest rates.

A yield inversion strategy refers to how you can use Treasury futures to manage risk during periods of economic uncertainties. Can yield inversion be used as a successful stock market indicator?

In this post, we answer some questions about the yield inversion strategy and we make a yield inversion backtest.

What Is a yield curve?

Also known as the term structure of interest rates, a yield curve is a graphical representation of the relationship between the interest rate paid by an asset and the time to maturity. It is a line that plots yields (interest rates) of different bonds issued by the same institution (bond with the same credit quality) against their different maturity dates — the interest rate is plotted on the vertical axis, while time to maturity is plotted on the horizontal axis.

The most commonly followed yield curve compares U.S. Treasury notes with terms of three months, two years, five years, 10 years, and thirty years. These yield curve rates are typically accessible on the Treasury’s interest rate websites by 6:00 p.m. ET on each trading day. The slope of a yield curve provides insight into potential future changes in interest rates and economic activity.

A yield curve is used to forecast changes in economic output and growth and serves as a benchmark for other types of debt on the market, such as mortgage rates or bank lending rates. In normal market situations, interest rates and time to maturity are positively correlated.

Thus, a normal yield curve is one in which longer maturity bonds offer a greater yield than shorter maturity bonds due to the risks involved with time. This makes sense because you would require a higher return the longer to maturity to compensate for the increased risk.

What is an inverted yield curve?

Normally, due to the risks associated with time, bonds with longer maturity periods have a higher yield compared to bonds with shorter maturity periods, and in that case, the yield curve is said to be normal.

However, there are times when shorter-term bonds have higher yields than longer-term bonds, the yield curve becomes inverted.

Sometimes referred to as a negative yield curve, an inverted yield curve is one that shows that long-term interest rates are less than short-term interest rates. With an inverted yield curve, the yield decreases the further away the maturity date is.

Yield curve inversion happens when investors are expecting some uncertainties in the economy (and equity markets) over the long term and therefore flock to long-term Treasury instruments, which they consider safe-haven assets to protect their wealth from the anticipated unhealthy equity market. As a result of the huge demand for longer-term Treasury bonds, their prices rise, and their yields fall, even falling lower than the yields of shorter-term bonds. Eventually, an inverted yield curve results.

In other words, an inverted yield curve shows that the whole market is becoming pessimistic about the economic prospects in the near future. This is why the inverted yield curve has proven in the past to be a fairly reliable indicator of a potential economic recession.

What can an inverted yield curve tell an investor?

An inverted yield curve shows that investors are generally shifting funds from short-term bonds to long-term ones. It happens when investors are expecting some uncertainties in the economy (equity market) over the long term.

In such a situation, investors flock to long-term Treasury instruments, which they consider safe-haven assets to protect their wealth from the anticipated unhealthy equity market, thereby creating more demand, higher prices, and lower yields for long-term treasuries.

As an investor, this tells you that the market as a whole is growing more pessimistic about the economic outlook. The economy is not doing well, and the market participants are seeking safe havens.

What is an example of an inverted yield curve?

As of writing in December 2022, the market is currently witnessing a yield curve inversion in US Treasury instruments. Against a backdrop of surging inflation (with the Fed’s unrelenting increase in interest rates) and a bearish equity market, the yield curve is getting inverted again.

For example, on December 7, 2022, Treasury yields for the various maturity periods are as follows:

• Three-month Treasury yield = 4.37%
• Six-month Treasury yield = 4.74%
• One-year Treasury yield = 4.73%
• Two-year Treasury yield = 4.34%
• 5-year Treasury yield = 3.73%
• 10-year Treasury yield = 3.51%
• 30-year Treasury yield = 3.52%

You can see that from the six-month T-bills to the 10-year T-notes, the yield consistently gets lower as the maturity period increases. But according to Treasury experts, the key periods of interest when checking for yield inversion are the 2-year and 10-year maturity periods.

Clearly, we are witnessing an inverted yield curve and this doesn’t happen that often. Let’s explain how rare this is:

What are some historical examples of this occurrence?

Historically, there have been a few occasions when the 10-year to 2-year Treasury yield inversion occurred, and it has been a generally reliable recession indicator since the mid-1960s. Here are some examples:

• In late 1981, there was an inversion of the yield curve, with a huge spread of more than 0.77 percentage points between the 2-year yield and the 10-year yield, which was followed by a deep recession.
• In 1998, the 10-year/2-year yields inverted briefly after the Russian debt default. While quick interest rate cuts by the Federal Reserve helped avert a U.S. recession, the recession would eventually come at the turn of the century.
• In 2006, the 10-year/2-year yields inverted, and it was followed by the Great Recession in 2007.
• In August 2019, the 10-year/2-year spread briefly inverted, which was followed by a two-month recession in February and March 2020 amid the emergence of the COVID-19 pandemic.
• In 2022, another 10-year/2-year yield inversion has occurred and experts suggest that a recession may be unavoidable.

A chart example of an inverted yield curve

The yield curve is often plotted as a line graph, with the yields on the y-axis and maturity periods on the x-axis. Normally, if the higher maturity periods have higher yields, the yield curve would slant upward, from left to right. But in an inverted yield curve, the line slopes downward from left to right. Take a look at the inverted yield chart below:

You can see that from the six-month T-bills to the 10-year T-notes, the yield consistently gets lower as the maturity period increases. The longer the maturity, the lower the rate (and thus inversion).

Why is the 10-Year to 2-Year spread used mostly for the yield curve?

In checking for a yield curve inversion, many investors use the spread between the yields on 10-year and 2-year U.S. Treasury bonds as a yield curve proxy and a relatively reliable leading indicator of a recession in recent decades. The reason is that over the years, those two yields have given the most consistent inversion signals for predicting a recession.

However, some officials at the Federal Reserve have argued that a focus on shorter-term maturities is more informative about the likelihood of a recession. But investors still focus on the 10-year/2-year spread.

What is a negative yield curve?

A negative yield curve is another name for an inverted yield curve. It shows that long-term interest rates are less than short-term interest rates. That is, the yield decreases the further away the maturity date is. This happens when investors are expecting some uncertainties in the equity market over the long term and therefore flock to long-term Treasury instruments, which they consider safe-haven assets to protect their wealth from the anticipated unhealthy equity market.

The negative yield curve indicates that the whole market is becoming pessimistic about the economic prospects in the near future. So, it is considered a fairly reliable indicator of a potential economic recession.

What does it mean when the yield curve steepens?

When the yield curve steepens, it means that the yields are rising faster than the maturity period is increasing. That is, the yields for longer-term maturities are much higher than those of shorter-term maturities. This is typically observed at the start of economic growth. Short-term interest rates, which were probably cut by the Fed in an effort to stimulate the economy, will thereafter have fallen due to the economy’s stagnation.

As you know, the rise in the demand for capital, is one of the first indications that the economy is recovering as it starts to expand once more. With investors in long-term bonds currently concerned about being trapped into low rates, which might reduce their purchasing power in the future if inflation occurs, they want larger payments in the form of increased rates.

What does it mean when the yield curve flattens?

When the yield curve flattens, it means that the shorter-term yields are getting closer to those of longer-term yields. In fact, before a yield curve may invert, it must first go through a period in which short-term rates climb to levels closer to long-term rates. When this occurs, the curve will appear to be level or, more frequently, to have a tiny elevation in the center in which case it is called a humped yield curve.

A flattened yield curve heralds the inverted yield curve. However, not all flat or humped curves become totally inverted curves. Nonetheless, you shouldn’t ignore them, because many times in the past, a period of flattening yields is followed by an economic downturn and lower interest rates.

Can the yield curve foresee a recession?

Yes, investors consider an inverted yield curve a good predictor of recession. Since the 1960s, yield curve inversion has always preceded a recession with high accuracy — only one false positive. However, while an inverted yield curve has often preceded recessions in recent decades, it does not cause them. It is only a reflection of the actions of market participants.

Why is the yield curve inverted in a recession?

The yield curve inverts prior to a recession because investors try to protect themselves during periods of uncertainty. Whenever investors anticipate uncertainty in the market, they flock to safe-haven assets, such as Treasury instruments. In trying to lock in the best interest rate for a long time, they invest in longer-term Treasuries, thereby pushing the demand for them up and their yields down.

How many times has the yield curve inverted?

According to Statista, there have been about 6 major yield curve inversions in the past before the current one in 2022. These previous yield curve inversions are as follows:

• August 1978
• September 1980
• June 1989
• February 2000
• January 2006
• August 2019

See the chart in the image below:

Below is a chart that shows the yield curve between the 2- and 10-year difference since 1976:

In total, the yield curve has inverted (going negative and then going positive before again going negative) 44 times since 1976, but they tend to be clustered in small time windows.

How long after an inverted yield curve does recession happen?

It varies. There is no specific period. From the chart above, you could see that the duration varies from 6 (between the August 2019 and February 2022 pandemic recession) months to 22 months (between January 2006 and the Great Recession of November 2007).

What happens to stocks after the yield curve inverts?

On many occasions, by the time the yield curve inverts, stocks were already in a bear market.

Does inflation cause an inverted yield curve?

Inflation does contribute to a yield curve inversion. Rising inflation often leads to higher interest rates and higher borrowing costs, which may lead investors to try to lock up higher interests in bonds. However, inflation is not the only cause. Yield curve inversion is generally caused by a weak economy.

Is an inverted yield curve good for stocks?

Yield curve inversion is a sign of an impending recession but the stock market looks ahead and discounts the recession bere it actually happens. The answer is found in our backtest further below in the article.

What are the four types of yield curves?

They are as follows:

• Normal yield curve: A normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time.
• Flattened yield curve: This precedes an inverted yield curve and indicates rising short-term yields that are getting closer to long-term yields.
• Inverted yield curve: An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields.
• Steep yield curve: This implies rising long-term yields compared to short-term yields. It happens when the economy is recovering and expanding after a recession.

Yield curve inversion strategy backtest (How to trade an inverted yield curve?)

Let’s go on to look at a yield curve inversion strategy backtest with strict trading rules and settings.

First, we make a chart showing S&P 500 and the yield curve:

The time frame is pretty long so it’s hard to spot any anecdotal tendencies. Only a backtest can help us! Let’s go on to make a couple of backtests:

Yield curve inversion strategy backtest no. 1

Our first backtest of the day has the following trading rules:

• When the yield curve gets inverted (ie crossing below zero), we buy S&P 500.
• We sell 250 trading days later.

Since 1976 we have had 11 trades and the average gain over the next 250 days is 7.35% (which is more or less the same as the average annual return over the last 60 years). The win rate is 63% and the equity curve looks like this:

Here are the dates on the yield curve inversion trades:

Now, what happens if we hold longer, for example, 500 days?

The number of trades drops to 7, but the average gain increases to 18.3%, something that is higher than a random 500-day period. The trades are listed below:

Yield curve inversion strategy backtest no. 2

Let’s make a completely different yield curve inversion strategy backtest. We make the following trading rules:

• When the 5-day RSI of the yield curve (2-year yield minus the 10-year yield) is below 20, we buy S&P 500.
• We sell when the 5-day RSI turns above 80.

The historical performance looks like this:

There are only 102 trades since 1976 (too few to get reliable statistics and metrics?), but the average gain is 2.5% and you are invested almost 3 months per trade (exposure is 50%). This is slightly better than any random period.

Yield curve inversion strategy – academic research

The famous academics Eugene Fama and Ken French have also published research papers on yield curve inversions. The title of their research was called Inverted Yield Curve and Expected Stock Returns.

Fama and French used the same time frame as we did: from 1975 until 2019 (we did to December 2022, though). The pair had a very simple hypothesis:

Can the yield curve predict the stock market underperforming short-term treasury bills?

They backtested 11 major stock and bond markets and compared six different yield spreads and switched from stocks to T-bills when any of the 6 curves inverted. When it inverted, they measured the performance over the next one, two, three, and five-year periods.

We quote their conclusion:

We find no evidence that yield curve inversions can help investors avoid poor stock returns….With the diversification of 11 or 12 countries and 60 months after each inversion, almost all the expected five-year premiums for the active World and World ex. USA strategies are reliably negative.

The markets they looked at (US stock market, world stock market, world ex-US stock market) and the futures strategy of switching from stocks to cash underperformed a buy and hold strategy.

List of trading strategies

Since this blog’s inception back in 2012, we have written more than 800 articles. Many of those articles contain strategies (including this article), and we have compiled many of those into a package of code that you can order. We have thus far over 160 different strategies in our compilation.

The strategies are taken from our list of best trading strategies. The strategies are an excellent resource to help you get some trading ideas.

The strategies also come with logic in plain English (plain English is for Python traders).

For a list of the strategies we have made please click on the green banner:

These strategies must not be misunderstood for the premium strategies that we charge a fee for:

FAQ yield curve inversion

Based on the number of e-mails we get we decided to make a FAQ to better address any issues about yield curve inversions:

What is a yield curve inversion?

A yield curve inversion occurs when short-term interest rates are higher than long-term interest rates. This is the opposite of the normal pattern of yields, where longer-term rates are higher than shorter-term rates. A yield curve inversion is often seen as a sign of an impending recession, since it can indicate that investors expect lower growth and inflation in the future.

What causes a yield curve inversion?

A yield curve inversion can be caused by a variety of factors. These include changes in monetary policy, rising short-term borrowing costs, and a decrease in demand for long-term bonds. When short-term interest rates rise faster than long-term rates, the result is a yield curve inversion.

However, in 2022 we have witnessed a “constant” yield curve inversion despite inflation running at 9%. Long-term rates are hovering around 3-4 while short-term rates are higher, thus the market signals it expects rates and inflation to subdue significantly in the future. Bond traders take the view that the FED will do “whatever it takes” to get inflation back down.

What is the impact of a yield curve inversion?

A yield curve inversion can have a significant impact on the economy. It can slow economic growth, as businesses and consumers become less willing to invest and spend. In addition, a yield curve inversion can make it more difficult for businesses to access credit, as lenders become less willing to lend money at lower interest rates.

What can investors do about a yield curve inversion?

Investors should take a long-term view when considering investments in a time of yield curve inversion. Investors may want to consider alternative investments such as hedge funds, private equity, and venture capital to protect against the potential impacts of a yield curve inversion.

Yield Curve Inversion Strategy – Conclusion

Any yield curve inversion gets a lot of publicity, but our backtests indicate you might be better off looking elsewhere for trading/investing indicators. Most likely, any yield curve inversion strategy is too late for the party (?).