I hear it brought up almost daily in the financial press. And it’s a notion that I hear a lot of investors in the news lean on when trying to justify their bullish inclinations. It is the yield curve. But unfortunately for stock bulls relying on this indicator, its deceiving shape in today's market may be lulling them into a trap.
The yield curve is a measurement that is used to track the movement of interest rates over time. A common way to express the yield curve is through the yields associated with U.S. Treasuries of varying maturities ranging from 3 month T-Bills (3M) to 30-Year Treasury Bonds (30Y). This is shown in the chart below.
(Click charts to enlarge)
The Treasury yield curve presents itself in several ways over time. These are outlined below:
Normal Yield Curve: Under normal conditions, the yield curve slopes higher with short-term Treasuries having a lower yield than long-term Treasuries. This is due to the fact that when economic conditions are stable, investors need to be compensated with more income for committing their money for longer periods of time. A normal yield curve is found during periods of sustained economic expansion, which is generally a favorable time for stocks.
Steep Yield Curve: A steep yield curve is much like a normal yield curve, but it is differentiated by the fact that the yield on long-term Treasuries becomes a lot higher (generally +2 percentage points or more) than the yield on short-term Treasuries. A steep yield curve often occurs around economic troughs where recessions end and new expansions begin and is typically the result of the Fed having lowered interest rates to stimulate the economy. Such are particularly positive conditions for stocks in a normal environment.
Inverted Yield Curve: The yield curve becomes inverted when short-term rates actually become higher than long-term rates. This can be caused by several factors including the Fed hiking short-term interest rates to slow economic growth coupled with investors moving to safety and accepting lower long-term rates as they brace for a weakening economy. Thus, an inverted yield curve typically occurs around economic peaks where expansions end and recessions begin. Such are particularly negative conditions for stocks in a normal environment.
Today, we still have a steep yield curve despite some flattening in recent weeks. And I often hear pundits in the financial news support their bullish stock positions and attempt to refute the likelihood of a recession because we still have a steep yield curve. They also try to refute the possibility of a double-dip recession because the yield curve is nowhere near inverted.
Now if we were operating in a normal economic cycle, I’d most likely agree with these premises. But here’s the problem. We’re not operating in a normal economic cycle today. To the contrary, we remain in the throes of a financial crisis that remains unresolved for over four years now since its initial outbreak. Thus, relying on the yield curve to provide its traditional signals during the normal business cycle sets investors up to get caught in a nasty bear market trap.
The response to the financial crisis has distorted the yield curve and its readings. First, due to the Fed’s policy of maintaining short-term interest rates at 0%, the short-end of the yield curve is effectively pinned to the ground. Sure the yield curve is rising, because any yield whatsoever to compensate investors for committing their capital for any period of time is going to be greater than 0%. Second, you simply can’t have an inverted yield curve if short-term interest rates are at 0%. Unless the U.S. government starts charging people to lend them money, it is a technically impossible outcome.
If anything, a dissection of the yield curve paints a fairly dire picture at present. On the short end of the curve, the fact that the Fed has had a 0% interest rate policy in effect since late 2008, and recently committed to keep this policy in place until mid 2013, indicates how desperately the Fed is continuing to work to try and stimulate economic growth. To this point, it continues to provide maximum stimulus and these efforts have not gained traction. And if anything, one should read the extended future commitment to keep interest rates at 0% as an expectation that we’re still not going to see sustainable economic growth any time soon.
Moving to the long end of the curve, we’ve actually seen a meaningful flattening of the yield curve in recent weeks. For example, since the end of the second quarter a mere seven weeks ago, we’ve seen a 25 basis point drop in the 2-year yield and a 96 basis point drop in the 10-year yield. This is a meaningful flattening over a short-term period of time and is also a bearish sign for the economic outlook. Basically, we not seeing the economic acceleration signaled by the steep yield curve. Instead, investors are moving to safety and accepting increasingly lower long-term rates as they brace for a slowing economy.
These two yield curve forces suggest that the economic recovery never gained traction in a sustainable way and now investors are throwing in the towel and bracing for another economic slowdown.
Supporting the these yield curve conclusions is the experience we’ve seen in Japan in the aftermath of the financial crisis going back to the 1990s. The Japanese have had a normal-to-steep yield curve for well over a decade. And they’ve had short-term interest rates continuously pinned at 0% with very brief exceptions since late 1999. An inverted yield curve never happened along the way, simply because it couldn’t. Yet the Japanese economy has experienced seven recessions over the past two decades including five since the Bank of Japan pinned short-term interest rates at 0%. And none of this was bullish for the Japanese stock market.
So when formulating an economic and stock market outlook, beware relying too much on the yield curve. While it is a fairly reliable indicator during normal economic times, these are far from normal times. And during periods of financial crisis like today with short-term interest rates pinned at 0%, it is worthwhile to take a closer look at the yield curve and dissect its movements much more closely before drawing any final conclusions. While at first glance it might be tempting to think that today’s yield curve is providing a positive signal for stocks, beware the potential trap, as a closer look reveals a vastly more troubling picture for stocks going forward.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.
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