The Bond Market Is Setting Up a Contrarian Trade

The banking crisis in March was supposed to fix the broken yield curve.

The yield curve measures the difference between short- and long-term rates. And it slopes upward during normal market conditions.

But when it inverts, the economy gets put on notice.

We don’t see the effects right away, as the lag effect tends to take around 6–24 months to develop.

In our current case, the yield curve first inverted on March 29, 2022. It travailed until July 1, then collapsed to levels not seen since the early 1980s.

And it continued to invert even more until its low on March 8.

One day later, word got out that Silicon Valley Bank (SVB) was in trouble before abruptly collapsing within 72 hours.

So the lag effects of an inverted yield curve took around 12 months to develop with the banking fallout.

From there, the yield curve took off. The market thought the Fed would stop raising rates in light of the damage to the banking sector.

This was the boost the market needed to take off, with the Nasdaq-100 (NDX) rising 23% – or 13% better than the S&P 500 (SPX).

Now, as you could see in the chart, we’re right back down at the lows again.

We’re back to the most inverted levels we’ve seen since the SVB fallout.

That means the same issues with bank balance sheets that caused several of them to go underwater still persist.

We’re now in a new phase of that inversion, and the lag effects are lurking more ominously.

That’s because underlying economic indicators, like the jobless claims and the ISM services Purchasing Managers’ Index (PMI), have been trending in the wrong direction.

And that’s why the Fed has opened the door for the “skip” in rate hikes last week to turn into an outright “pause.” If those indicators continue to trend, it will ultimately result in rate cuts.

The inflation rate is continuing down as demand from the perspective of commodity prices continues to trend lower.

Oil, for instance, can’t catch a bid. Even the second surprise production cut from OPEC (Organization of the Petroleum Exporting Countries) in early June couldn’t hold prices up.

It all comes amid the backdrop of the extreme shift you can see in the chart of American Association of Individual Investors’ (AAII) sentiment readings.

The chart above brings the adage that “bulls live higher and bears live lower” to life, buying high and selling low.

The massive leg higher in large-cap tech got the remaining bears to throw in the towel and join the party in the 12th hour.

Last week’s FOMC rate decision took the market higher still into the weekend. The Invesco QQQ Trust Series 1 (QQQ) rose 2% from the lows last Wednesday.

Sentiment is reaching an extreme.

This all sets up the biggest contrarian trade for the second half of the year.

The yield curve will bottom out as the Fed will back away from its tightening cycle.

That sets up the right time to position portfolios back to the traditional 60/40 (60% stocks and 40% fixed income) portfolio weighting. 60/40 has been the linchpin of passive investment theory for decades, but it failed in 2022 amid the yield curve inversion.

But I would go a step further and switch that weighting around – with 60% going to U.S. Treasurys with an emphasis on overweighting short-term Treasury notes.

As for the 40% equity weight, the time-tested principles of buying low and selling high will make large-cap tech a laggard in the second half relative to the S&P 500.

Regards,

Eric Shamilov
Analyst, Trading With Larry Benedict

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