Analysts seem to move quickly from indicator to indicator. When markets are rising, analysts often claim there’s no need to consider extreme valuations or overbought technical indicators. When prices start falling, it seems like we need to worry about those indicators.
However, no matter what the market is doing, analysts do tend to agree that we should consider the state of the economy. Economic growth is synonymous with bull markets and bear markets tend to unfold when the economy is contracting.
There are hundreds, if not thousands, of economic indicators. Some are forward looking and others are lagging. For example, unemployment tends to follow economic trends while new orders indexes tend to lead the economic cycle.
One indicator that seems to be forward looking and has a significant relationship to the stock market is the yield curve.
A yield curve is defined as a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates. The most frequently reported yield curve compares the three month, two year, five year and 30 year US Treasury debt.
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This yield curve is used to predict changes in economic output and growth.
The Shape of the Curve Is an Indicator
Two examples of the yield curve are shown below. The lower line in the chart is the current yield curve. The upper line is the yield curve in February 2000, just before the stock market crashed that year.
Right now, a normal yield curve exists. A normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter term bonds due to the risks associated with time.
In 2000, an inverted yield curve can be seen. This is a yield curve where the shorter term yields are higher than the longer term yields, which can be a sign of an upcoming recession.
Economists, in addition to stock market analysts have studied the yield curve. In particular, economists at the Cleveland Branch of the Federal Reserve have reviewed the usefulness of the curve as an economic forecasting tool. They note:
“The slope of the yield curve—the difference between the yields on short and long term maturity bonds—has achieved some notoriety as a simple forecaster of economic growth.
The rule of thumb is that an inverted yield curve (short rates above long rates) indicates a recession in about a year, and yield curve inversions have preceded each of the last seven recessions (as defined by the NBER).
One of the recessions predicted by the yield curve was the most recent one. The yield curve inverted in August 2006, a bit more than a year before the current recession started in December 2007. There have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998.
More generally, a flat curve indicates weak growth and, conversely, a steep curve indicates strong growth. One measure of slope, the spread between ten year Treasury bonds and three month Treasury bills, bears out this relation, particularly when real GDP growth is lagged a year to line up growth with the spread that predicts it.”
The chart below summarizes this relationship.
Source: Federal Reserve
Application to Market Analysis
Economists have found that the shape of the curve is important. This is logical. When the economy is growing, demand for money should increase. This will push interest rates up. We expect rates on a 10 year loan, for example, to be higher than the rate of a 30 day loan. That relationship is the curve.
As demand for money decreases, potential borrowers are signaling that they have fewer investment opportunities. Lower demand leads to a decline in interest rates. The longer term loans should see the greatest decrease in demand and the curve should flatten, or even invert.
To convert this idea into a useful indicator, we could simply subtract the value of short term rates from the value of long term rates. This results in the next chart which subtracts the interest rate on 2 year Treasuries from the interest rate in notes with 10 years to maturity.
The chart shows that the curve inverted before the 2000 and the 2008 bear markets. The down trend in the curve reflects the slowing economic growth that has characterized the current economic expansion.
In the chart, we can see that the trend in the yield curve is down but we also see that the current level of the difference between long and short term rates is relatively far above an inversion.
What to Watch For
Of course, the yield curve will change over time. The Federal Reserve is raising short term rates. The Fed does not set long term rates. It is possible the next inversion will be caused by long term rates declining even as the Fed boosts short term rates.
That would be a signal that the market is not enthusiastic about the prospects of economic growth and the lower demand for long term loans would reflect that opinion.
However, there are also reasons to expect long term rates to rise. The Fed is no longer buying bonds and the Treasury Department will need to issue more bonds to finance the large budget deficit. This could result in higher long term rates, even if the economy contracts.
These factors mean the yield curve is just one indicator that investors should watch. If it inverts, there is a near certainty of a recession and a bear market in stocks. However, even if there is no conversion, a bear market is still possible.
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