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The Alpha Team. How to Construct a Global Portfolio After a Yield Curve Inversion. Yield Curve. Professor Campbell Harvey developed a widely used measure called the yield curve to predict US Recessions Yield curve is the difference between long-term and short term interest rates
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The Alpha Team How to Construct a Global Portfolio After a Yield Curve Inversion
Yield Curve • Professor Campbell Harvey developed a widely used measure called the yield curve to predict US Recessions • Yield curve is the difference between long-term and short term interest rates • With an inversion short-term rates are greater than long-term rates indicating a shift in investors expectations
Goals • We wanted to investigate the international capacity of the yield curve measures. • First we wanted to see if the inversion of the yield curve predicted recessions in countries that are highly correlated with the US • If so is there a consistent relationship between lag lengths? • Secondly, does the inversion of the US yield curve indicate an inversion of the local yield curve measure? • Finally, does the yield curve inversion for local yields or for the US yield curve provide us with a simple profitable trading strategy for these countries?
Is the US Yield Curve predictive for recessions in foreign countries? • The US yield curve has had much success in predicting US recessions, but does it also predict recessionary periods in the countries that are highly correlated with the US? • To answer this question we first gathered data from the ten most heavily trading countries with the US • Canada, Mexico, Japan, China, Great Britain, Germany, France, South Korea, Taiwan, and Australia • Then looked for possible correlations between the US yield curve inversion with a possible recession in the foreign countries
Trade Balances Over Time • How the trade between the US and these countries changes over time is important when analyzing the impact of the yield curve measure • The expectation is that as trade increases the impact of the yield curve also increases
GDP and US Yield Curve • Is the US yield curve a predictor for foreign recessions?
Country Specific Yield Curves • The impact of the yield curve on GDP for foreign countries does not appear to be significant • The impact did not grow with trade (this result is further vindicated in our regression analysis) • Does an inversion in the US yield curve indicate inversion of country specific yield curves?
GDP and Yield • As shown above an inversion in the US yield curve could be an indication that countries such as Canada might also suffer a yield curve inversion • Does the inversion of a country specific yield curve act as a reliable measure for recessionary periods?
Local Yield Curve • The local yield curve measures do not appear to be dependable predictors of local recessionary periods in GDP • Further statistical tests should be preformed
Yield Curve and Equity Markets • Due to the fact that the US yield curve had little predictive power as to foreign recessions we turned our attention to the equity markets • Does the US yield curve have predictive power for foreign equity returns?
Yield curve inversion coincides with a negative/depressed average return. • Holds for all periods expect September 1998 to December 1998. • Russian Government Default • LTCM Bailout
Trading Strategy • Long position during contango, short position during inversion. • Is there a lag between inversion and negative equity return? • Yes, but built in.
Trading Strategy • Extend this strategy to foreign equity. • Three Correlation Groups • High • Middle • Low
Trading Strategy • Exclude February 1990 to August 1998 and September 1998 to December 1998. • Strategy holds for 97 out of 106 periods. • 91.5%
Trading Strategy • Trading strategy as a simple linear regression. • Equity Returnt=+*Inversion Dummyt+*Inversion Dummyt*US5Y-3Mt • Expect the dummy coefficients to be negative. • Exceptions (Germany, China, Korea, Mexico, Taiwan