Yesterday, on CNBC’s Fast Money, Tony Dwyer, Chief Market Strategist & Co-Director of Research at Canaccord Genuity, said something very interesting. He said, “Until you invert the yield curve, history has proven and proven and proven, you never ever ever ever want to sell a correction when you are not in a recession environment after an inversion of the yield curve.”
So i think this is both a fascinating and fabulous statement. But before we discuss why this is important, we probably have to explain a few things.
Inverting the yield curve means when the short term Treasury rate is higher than the longer term. Usually, market watchers will compare the w-year or the 3-year against the 10-year Treasury. Normally, in a healthy market environment, the shorter term interest rate is lower than the longer. If you think about it, that makes sense – your interest rate on a 10-year loan should be longer than your interest rate on a 2-year loan. This is the situation today.
At times, the yield curve is inverted. That is, the 2-year can be higher than the 10-year Treasury. Market watchers say that if this happens, a recession is likely 6 to 18 months after. This is because investors are moving money into the safety of short term bonds, driving up the shorter term interest rates. The longer term rate falls because weaker economic conditions are expected, and longer term rates are expected to fall. Notice that in the years following the 2008 crisis, the Fed lowered interest rates in response to a weakened economy and a falling stock market.
In this context, Tony Dywer’s comment makes a lot of sense. He’s saying, if the yield curve inverts, you shouldn’t sell a correction unless you are in a recession. So even if the yield curve inverts, things may not get worse, and you should not sell when the market is down unless there is a recession. If there is a recession AND the yield curve inverts, then you should sell a correction, because things are expected to get worse.
I find this very interesting because the human tendency is always to want the correction to buy, but when the correction occurs, it’s very hard to actually buy because many are saying things will get worse. So Tony is saying, you can buy the correction, because things will get better. The exception, the time you don’t want to buy, is when the yield curve is inverted and there is a correction. And this helps because you need something to counter all the negative press when markets fall. You need a reason to buy the dip, and he’s providing one. Nifty.