ETFs That Benefit With the Inverted Yield Curve

Stocks tumbled last Wednesday on yield curve inversion hysteria as the spread between the yields on 10-year U.S. Treasury notes and those of 2-year notes went negative for the first time since the financial crisis. But rather than warning its clients to get out of the equity market, Bank of America recommends a couple of exchange-traded funds (ETFs) in the energy and technology sectors that are likely to benefit over the next 12 months.

An inverted yield curve has historically been a reliable warning sign that a recession is coming, the inversion of the 2s10s being an especially ominous signal. But it’s just a sign, not the thing that causes a recession itself, and history also tells us that pinpointing exactly when the presumed recession will hit is hard to do. Predicting when the damage will take its toll on equity markets is just as precarious an exercise.

What It Means for Investors

People make predictions nonetheless. Data from Credit Suisse showed that stocks typically have about 18 months of gains following the 2s10s inversion until returns start turning negative. BofA’s analysts indicate that the average and median length of time between inversion and the start of a recession is 15.1 and 16.3 months, respectively, according to CNBC.

“Sometimes the S&P 500 peaks within two to three months of a 2s10s inversion but it can take one to two years for an S&P 500 peak after an inversion,” wrote BofA technical strategist Stephen Suttmeier. “The typical pattern is the yield curve inverts, the S&P 500 tops sometime after the curve inverts and the US economy goes into recession six to seven months after the S&P 500 peaks.”

Given that there may still be some time left before the decade-long bull rally ends, BofA strategist Mary Ann Bartels recommends the Energy Select Sector SPDR ETF (XLE) and the Vanguard Information Technology ETF (VGT). Her recommendation is based on how the sectors to which the funds belong historically perform during the 12-month period following a yield-curve inversion as well as specific characteristics of the funds themselves.

The energy sector has outperformed the broader equity market by an average 7.3% during the 12 months following each of the seven inversions of the 2s10s yield curve since 1965, and has done so 80% of the time. Combine that historical performance with the sector’s recent underperformance, which could act to cushion it from broader market weakness, and energy stocks suddenly look like strong candidates to be winning bets over the next year.

What makes the XLE especially attractive among other energy ETFs are its efficiency characteristics—characteristics that provide maximum results with minimal input—and technical characteristics. The fund has a competitive expense ratio (ER), the best NAV tracking, highest secondary market liquidity, tightest trading spreads, and price momentum 300 bps above the peer average, according to Bartels.

While not quite as strong as the energy sector, the tech sector has also historically outperformed the broader market during the 12 months following yield-curve inversions since 1965. Tech is also the sector that is most globally exposed to momentum and growth, which are both factors that tend to outperform at the end of bull markets. The VGT is BofA’s top tech pick, having the second lowest expense ratio among its peers, relatively tight trading spreads, and decent price momentum. 

While some sectors have shown to rally on the yield curve’s inversion, others have faltered. Consumer discretionary, unlike energy and tech, has underperformed the broader stock market by 9.1% during the 12 months following every 2s10s inversion since 1965. 

Looking Ahead

But not all inversions of the yield curve are the same. Since it is just a warning sign and not a causal factor, any inversion should be weighed against other economic indicators and placed within the greater macroeconomic context. On that note, the ongoing U.S.–China trade war amid signs of a slower growing global economy affirm the bearish outlook.