Most investors or traders spend the majority of their time
looking for the next stock, less often the next sector to be rotated into.
On the other hand, they spend little time considering the health of the
market or the particular sectors within it. That's true even though as much
as 80 percent of a stock's price movement depends on the combination of the
two. So why aren't we more interested? I suspect it's probably because most
don't know how to effectively evaluate the health of either sector or market
conditions, or how to use the information if they knew where to find it.
Bill O'Neil has popularized the concept of "follow through
days" as an approach to identifying market bottoms and the accumulation of
distribution days as an approach to identifying market tops. In this
article, I'll discuss another key piece of information that's readily
available, the yield curve or the inter-relation among treasury security
rates over a range of expirations (most commonly from 3 months to 20
years). The top chart below shows examples from 1990 through 2005.
The yield curve is important because it provides insight into
where we currently are in the business cycle, which, in turn, is a major
driver of stock market's price. A yield curve is developed directly from
the financial markets, and as such, it reflects the collective wisdom of
investors at any moment in time as to the likely direction of the economy
and particularly the chance of future inflation. A flattening or inversion
of the relationship between short and long term treasury rates has preceded
every U.S. recession in modern history, all six since 1960. Curve 1 below
is an example: the S&P fell 20.4 percent over four months following this
curve. It pays to be aware of how the yield curve is changing. The chart
below further shows examples of other yield curve shapes that have occurred
In a normal yield curve, yield
starts is lower for the short maturities and gradually rises as the duration
increases, like curve 5 above. It reflects a typical economic expansion,
investors demanding a higher rate of return with the longer maturities for
all the unknown future economic risks, e.g., inflation swings,
political turmoil, and war. Those buying the shorter-term notes have less
risk to worry about, hence accept a lower yield.
A flat yield curve results when
the Federal Reserve intervenes and raises short term rates to combat
expected future inflation. Bond holders at some point recognize the risk of
a Fed induced recession and buy longer term bonds to lock in higher rates.
This buying pressures causes bond values to rise and their respective rates
to fall, i.e., there is an inverse relation between bond rates and
bond value. A flat curve is the first major warning that the economy is in
danger of slipping into recession. The chart below shows three time periods
(in yellow) where the Fed increased short-term rates to ward off inflation.
Notice in each case, the short term notes increased yield (green curve) and
the yield curve flattened--evidenced here by the difference in 3 month and
10 year yields (curve in red).
Finally, an inverted curve, like
what occurred in late 2000 (area of negative red curve below) reflects the
view that the Fed is keeping short-term rates too high, money is getting
scarce, and an economic downturn is virtually certain. In the case below,
the S&P fell 50.5 percent over the next few years.
The point of all this is that
we're there again: the FED is tightening and the yield curve is flattening,
though as shown by curve 9 above, we're a long way from the conventional
flat yield curve to this point. A study by the Federal Reserve Bank in New
York calculated the probabilities for a recession based on yield curve
characteristics: if the yield curve is normal so that the 10-year Treasury
bond yield exceeds 1.2 percentage points above the 3-month bill, the chance
for recession is less than 5 percent; once the yield curve flattens and the
two have essentially the same yield, the probability of recession increases
to 50 percent; if the curve inverts where the yield on a 3-month bills is
more than 2.4 percentage points above the 10-year bond, the odds leap to 90
percent than an economic downturn will materialize within the next 18
Once a recession is underway,
short-term rates plunge as the demand for money and credit fall, i.e.,
as corporations tighten their belts. The Fed, in turn, pumps money into the
economy to make borrowing cheaper and stimulate the economy. The greater
money supply causes the long-term bond values to fall and inversely, the
yield curve to steepen. Curve 4 above provides an example of the return to
the more normal 2.5 percent spread.
True inverted yield curves are rare, but
never ignore them. They are always followed by economic slowdown (6 times
since 1960) -- or outright recession -- as well as lower interest rates
across the board. To fully invert, the yield must first flatten, but bear
in mind that not all
flat curves become fully inverted.
Just remember: anything
that increases the demand for long-term Treasury bonds puts downward
pressure on interest rates (higher demand = higher price = lower yield or
interest rates) and less demand for bonds tends to put upward pressure on
interest rates. A stronger U.S. economy tends to make corporate (private)
debt more attractive than government debt, decreasing demand for U.S. debt
and raising rates. A weaker economy, on the other hand, promotes a "flight
to quality," increasing the demand for Treasuries, which creates lower
yields. It is sometimes assumed that a strong economy will automatically
prompt the Fed to raise short-term rates, but not necessarily. Only when
growth translates or "overheats" into higher prices is the Fed likely to
I think that you would
agree, it pays to be aware of the yield curve shape, especially when the Fed
starts tightening. Yield curve shape makes a statement about the current
economy, and the economy impacts corporate profits, hence, the stock market
which is directly related to the economy.
View the current yield
Next week, I'll share the
advantages of buying the "gap" down (opens lower than preceeding day's
close) for fundamentally sound stocks like TSM stocks.