Yield Curve Inversion Spooks Markets: 5 Utility Picks

On Dec 4, U.S. markets suffered their worst reversal since October with investors waking up to a brand new headwind. For the first time in more than a decade, yields on Treasuries with shorter maturities exceeded longer-dated issues on Dec 3. In other words, the yield curve experienced an inversion. Traditionally, such a phenomenon heralds the coming of a severe economic downturn.

The trend continued into Tuesday and is likely to prevail in an environment where the Federal Reserve is firm on tightening the monetary environment. Utilities stocks were the biggest gainers of yesterday’s trading session.

Their superior diving yields and steady revenues make them good choices in a tough economic environment. Investing in this class of stocks would make for a smart move right now.

Why Does Yield Curve Inversion Happen?

On Dec 3, the yield on the three-year Treasury note exceeded the return on its five-year counterpart for the first time since 2007. The phenomenon continued on Dec 4, with the yield on the 2-year Treasury note surpassing the return on the 5-year note. Yields on other longer-dated securities tumbled, with the 10-year Treasury yield falling below 3%.

With returns on shorter duration securities exceeding those with longer maturity periods, the yield curve has inverted. This brings us to the yield curve itself, a graph of rates payable by government bonds until the principal amount has been paid. Usually, this graph slopes upward since long-term rates exceed short-term returns.

This means that when the yield curve inverts, short-term rates are exceeding their long-term counterparts. In other words, long-term bonds are in high demand, a phenomenon which pushes down their yields. This is because investors are taking a negative view of short-term economic prospects.

Does This Imply that a Recession is Up Ahead?

For this very reason, an inverted yield curve has historically been a reliable indicator of recession. But optimists think that the most crucial yield gap, the one between the 3-month and 1-year government notes has not inverted. They take this to imply that an economic downturn is unlikely in the near future.

But investment manager Doubleline’s CEO Jeffrey Gundlach thinks the inversion witnessed recently is a clear sign that the “economy is poised to weaken.” Speaking to Reuters, “bond king” Gundlach added that “the totally flat Treasury note curve is predicting softer future growth (and) will stay the Fed’s hand.”

His views have been echoed by Arthur Estrella, known for his seminal study of the predictive nature of the yield curve. Estrella has said that the flattening of this curve is a matter of great concern. Such a phenomenon is usually shortly followed by a recession.

Estrella thinks that if the Fed continues its rate hikes after December, an inversion of the spread between the 10-month and 3-month treasury securities is in the cards. This would virtually guarantee that a recession would follow in its wake.

Our Choices

The jury may still be out on what the recent yield curve inversion signals, as far as experts are concerned. But markets seemed to have made up their minds on Tuesday, with the Dow suffering an 800-point loss. Utilities closed at their highest level in a year with investors reaching for safe havens.

The above-average dividend yields and steady revenues make this class of stocks great options at a time when a downturn looks near. Adding them to your portfolio would make for a prudent choice. We have narrowed our search to the following stocks based on a good Zacks Rank and other relevant metrics.

Otter Tail Corporation (NASDAQ:OTTR) is primarily involved in the production, transmission, distribution and sale of electric energy.

Otter Tail has a Zacks Rank #1 (Strong Buy). The company has expected earnings growth of 10.2% for the current year. The Zacks Consensus Estimate for the current year has improved by 2.5% over the last 30 days.

Atlantic Power Corporation (NYSE:AT) is an independent electric power producer that owns interests in a diversified portfolio of independent, non-utility power generation projects and one transmission line situated in major U.S. markets.

Atlantic Power has a Zacks Rank #1. The company’s expected earnings growth for the current year is more than 100%. The Zacks Consensus Estimate for the current year has improved by more than 100% over the last 30 days.

Middlesex Water Company (NASDAQ:MSEX) treats, stores and distributes water for residential, commercial, industrial and fire prevention purposes.

Middlesex Water’s expected earnings growth for the current year is 42%. The Zacks Consensus Estimate for the current year has improved by 6.5% over the last 30 days. The stock sports a Zacks Rank #1. You can see Zacks Investment Research

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Written By: Zacks Investment Research