The Alpha Team

1. The Alpha Team How to Construct a Global Portfolio After a Yield Curve Inversion

2. 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

3. Industry Standard Measures of Yield Curve

5. 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?

6. 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

7. 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

11. GDP and US Yield Curve • Is the US yield curve a predictor for foreign recessions?

21. 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?

27. 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?

33. Local Yield Curve Inversions and GDP UK

34. Local Yield Curve Inversions and GDP Germany

35. Local Yield Curve Inversions and GDP Canada

36. 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

37. 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?

38. 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

39. Trading Strategy • Long position during contango, short position during inversion. • Is there a lag between inversion and negative equity return? • Yes, but built in.

40. Trading Strategy • Extend this strategy to foreign equity. • Three Correlation Groups • High • Middle • Low

41. Average Equity Returns

42. Average Equity Returns

43. Average Equity Returns

44. Trading Strategy • Exclude February 1990 to August 1998 and September 1998 to December 1998. • Strategy holds for 97 out of 106 periods. • 91.5%

45. 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