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Monday, June 21, 2021

SPX 500 vs SPX midcap 400 - Strategy to counter flattening yield-curve

By Century Financial in 'Investment Insights'

SPX 500 vs SPX midcap 400 - Strategy to counter...
SPX 500 vs SPX midcap 400 - Strategy to counter flattening yield-curve

*Trading in financial markets carries risk and can result in loss of capital
*This performance is only observed with historical backtests and not traded by the company

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The product and investment ideas do not consider the risk profile and financial position of the recipient and may not be suitable for everyone. Trading in financial markets and use of margin involves a significant risk of loss, which can exceed deposits. Please read the complete disclaimer carefully.

Last week, US Federal Reserve stunned the markets by its surprisingly hawkish tilt where 11 out of 18 members in favor of 2 rate hikes in 2023 suggesting tapering could be on the cards. Consequently, the US yield curve had its most significant 4-day contraction since the pandemic, which broke the reflation trade. The spread between 5s/30s Treasuries narrowed to 115.47, the tightest since November as investors unwound bets on a steeper yield curve in the bond market.

A flattening Treasury yield curve is a threat to the already-faltering global cyclical rally

A flatter yield curve would likely favor defensive names like healthcare and consumer staples stocks. Technology shares will also benefit as long-term yields fall. That could trigger a reversal of the inflows seen into cyclical shares since late last year. Industrial & material stocks could be prone to more losses. Besides, the contraction in spreads will likely hurt the earnings of financial stocks as banks typically borrow short-term and lend long-term.

The flattening of the U.S. Treasury curve- A long way to run!

The flattening of the U.S. Treasury curve is truly measured by the narrowing spread between 2-year and 10-year yields and there is a long way for that to run. In the past two decades, the Fed had two rate-hiking cycles that flattened the bond-yield curve. The first ended in 2006 and coincided with a yield narrowing of around 280bps. Meanwhile, the cycle that concluded in early 2019 helped to flatten the curve by around 175bps, though Treasury curve flattening was even deeper in reality because of the fallout from the European debt crisis. This time around, the signal from the Fed has kicked o a sequence, which has already shaved 26bps off the curve. But history suggests there is still a long way to go. Last time the treasury yields flattened, Health care, Tech, Consumer Staples sectors outperformed the market, while industrials, materials and financial sectors underperformed.

US treasury 2-10 year spread

Pair Strategy which involves long position on US SPX-500 Index and short position on US SPX midcap 400 Index could be a good way to capitalize on this trend.

Health care, Tech, consumer Staples & consumer discretionary account for ~60% of the SPX 500 index. (Amazon accounts for maximum weightage within the Consumer discretionary sector) On the other hand, industrials, financials, materials & consumer discretionary account for ~54% of SPX mid-cap 400.

US SPX 500 Index

Name Weight %
S&P 500 INFO TECH INDEX 27.17
S&P 500 HEALTH CARE IDX 13.10
S&P 500 CONS DISCRET IDX* 12.28
S&P 500 CONS STAPLES IDX 5.91
S&P 500 COMM SVC 11.22
S&P 500 FINANCIALS INDEX 11.13
S&P 500 INDUSTRIALS IDX 8.54
S&P 500 ENERGY INDEX 2.84
S&P 500 REAL ESTATE IDX 2.64
S&P 500 MATERIALS INDEX 2.62
S&P 500 UTILITIES INDEX 2.54

*Amazon Inc accounts for maximum weight in consumer discretionary index and is considered to be a growth stock

Data Source : Bloomberg
Date : 21/6/2021

US SPX Midcap 400 Index

Name Weight %
S&P 400 INDUSTRIALS IDX 17.88
S&P 400 FINANCIALS INDEX 15.01
S&P 400 MATERIALS INDEX 6.33
S&P 400 CONS DISCRET IDX* 14.49
S&P 400 INFO TECH INDEX 14.36
S&P 400 HEALTH CARE IDX 11.28
S&P 400 Real Estate 9.91
S&P 400 CONS STAPLES IDX 3.43
S&P 400 UTILITIES INDEX 3.40
S&P 400 ENERGY INDEX 2.05
S&P 400 COMM SVC 1.81

*Most companies are small/mid-sized which will be considered as cyclical stocks.

Data Source : Bloomberg
Date : 21/6/2021

Given the flattening of the yield curve and current sector weightings, SPX 500 is likely to outperform SPX mid-cap 400. Technical charts also suggest the same. The SPX/Midcap Ratio has bounced o the support zone as can be seen in the graph below and could rally further.

SPX/Midcap Ratio Chart

However, it is important to note that Trading pairs is not a risk-free strategy. The diffculty comes when prices of the two securities move contrary to the positions taken resulting in losses. Thus, it is important to adhere to strict risk management rules when dealing with such adverse situations.

Risks and Assumptions for Back-tested trading strategies
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The risks and assumptions listed here are not intended to be an exhaustive summary of all the risks and assumptions involved.
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The strategy might suffer from look-ahead bias which occurs due to the use of information or data in a study or simulation that would not have been known or available during the period being analyzed. This can lead to inaccurate results in the study or simulation.
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Future price movements may not be exactly the same as the historical price movements and this could lead to variation in performance.
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Testing can sometimes lead to over-optimization. This is a condition where performance results are tuned so high to the past they are no longer as accurate in the future.
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The model assumes no slippages in trading. Slippage refers to the difference between the expected price of a trade and the price at which the trade is actually executed.
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Drawdowns in actual trading can be higher than the tested system and losses could be significant in the event of leverage.
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Unforeseen events can lead to variation in performance from the tested trading strategy.
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The tested result has been computed with price feeds available from Bloomberg.
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The testing environment has not considered transaction or any other costs.
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Trading indicators used for the purpose of testing has been provided by Bloomberg.
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The strategy might suffer from data mining fallacy, selection bias and backfill bias.

Data Source: Bloomberg
Date: 21/06/2021

Arun Leslie John
Chief Market Analyst

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