Thu 6 Mar 2008
Picture du Jour: Yield curve points the way for stocks
Posted by Prieur du Plessis under Money, Markets, Investment
In an attempt to post content on my blog site more regularly but yet not to make daunting demands on readers’ time, I have decided to launch short articles styled as “Picture du Jour” contributions. The idea is to provide investors with topical and interesting graphs, together with a few explanatory sentences, that can aid them with their investment decisions. As they say: “A picture paints a thousand words.” But please be warned that the intention is only to stimulate readers’ thinking and not to present all the relevant arguments in each of the articles.
As one would expect in recessionary times, the Fed’s series of interest rate cuts have resulted in a steepening of the yield curve.
The graph shows the relatively flat yield curve (black line) immediately prior to the first rate cut in August 2007. As indicated by the red line, the yield curve has steepened dramatically since, i.e. shorter maturities have fallen significantly more than longer maturities.
The aim of this policy is to encourage shell-shocked banks to start lending again, and to start making profits so that they may be able to grow their way out of the credit crisis over time. In the light of the deteriorating economic situation and a banking system still frozen up, it seems that the yield curve may become steeper yet before the patient starts responding to the medicine.
In the words of John Mauldin, author of the Thoughts from the Frontline newsletter: “Bernanke practically promised more rate cuts … The Fed is going to cut and cut again … I think it likely they will go below 2%. They may stay there longer than we now think if I am right about a protracted and slow muddle-through recovery.”
This raises the question as to what the impact of the yield curve typically is on the stock market. The blue line in the chart below shows the US 10-year Treasury Note yield relative to the US 2-year Treasury Note yield. A rising blue line indicates a steepening yield curve, whereas a downward trend shows the opposite. A comparison with the S&P 500 Index highlights a broadly inverse relationship, i.e. stocks fall when the yield curve steepens and rise when the curve flattens.
Source: StockCharts.com
The above analysis is merely one cog of the wheel, but seems to point to more downside for US stocks. However, be cognizant of the fact that the stock market is a discounting mechanism and often starts moving higher before a reversal of the yield curve (see 2002/2003). It may still be a while before we reach this stage, and investment portfolios should in the meantime emphasize capital preservation rather than opportunistic trades.
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March 6th, 2008 at 5:12 pmYield curve points the way for US stocks…
A comparison of the US yield curve with the S&P 500 Index highlights a broadly inverse relationship, i.e. stocks fall when the yield curve steepens and rise when the curve flattens. Given the expectation that the yield curve may become steeper yet befo…
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March 6th, 2008 at 6:59 pm
Hi PdP: What your picture shows essentially is what we know: it takes 6-9 months for rate cuts (which results in rising yield curve) to work their way into the economy.
I would be careful about extrapolating the direction of the yield curve and the direction of equities; “broad generalities” as you say is more like it. The yield curve peaked in January, 2004 which was a good 9 months after the market bottom and coincided with the peak in equities (sp500) for the next year; by the way it would not surprise me to find stocks at this level in the near future.
As another example, stocks moved higher in tandem with the yield curve during 1991 to 1993.
Bottom line: a positive yield curve is a positive sign for equities but a difficult timing signal
March 6th, 2008 at 7:00 pm
Dear Mr. Prieur du Plessis:
There is a cause-effect relationship which seems to be inverted in your argument. The blue curve rises (the effect) when the red curve falls (cause). In effect, when stock prices fall the FED steps in and lowers interest rates.— In all these arguments, conspicuous by their absence are the consumers. The central issue at the present time is how to put money - spending money - in the pocket of the consumers. This is a tough issue worth your discussing in your next issue.
The only remaining fashion in which this can be done under present conditions is to increase the pay of the employed - or increase employment. Debt is no longer a feasible avenue. The private sector will not increase wages, since it is this very attitude that got us here in the first place (something that is hardly ever mentioned) and the government seems to be frozen in place - a consequence of the epsilon extention cultural symptom that has plagued us since with the boomer generation. And of course being in an election year doesn’t help either.
We are now living at the point of convergence of all ills - and hell is looming on the horizon. I leave you with these pleasant thoughts.
Best wishes,
Kiek C Valanis Ph.D.
March 6th, 2008 at 8:00 pm
One other thing….you should call your new feature “Picture du Prieur”!!
March 6th, 2008 at 11:33 pm
Guy Lerner: The French name “Prieur” means “Prior” in English or, more accurately, the one who prays in front. I appreciate that we need to do a lot of praying in order to navigate the markets profitably, but calling the articles “Picture of ‘Praying in Front’” - I’m not sure!
March 7th, 2008 at 4:13 am
More regular and timely postings would be greatly appreciated.
March 7th, 2008 at 7:39 am
PdP: Well “praying” certainly describes the market these days as a lot of hopes have been dashed for good or bad/ right or wrong. I still like the play on words even if I am clueless about the meaning.
On a more serious market note, I am working on this idea of a price failure. By this I mean, the markets really should have bounced sometime in the last 6 weeks but they did not and in fact, we can say that they are breaking down. The bounce was predicated on poor investor sentiment but despite this, the bounce has not materialized. Sentiment remains poor and within this context there is a high possibility that we could see an extended period of bearishness accompanied by a significant price drop. From 1970 to 1982 (secular bear market), the six failed signals lost another 14% on average following the price failure. From 1984 to 1998, the six signals only lost 4% on average and being the bull market period, these failures were more likely fake outs as prices rocketed back upwards in a short time period. We are in a bear market, and it appears that prices are in the process of failing (i.e., support levels not holding). While I am the first to be bullish when others are bearish, I think that time has passed and we should be entering capital preservation mode.
March 8th, 2008 at 2:35 am
As Kirk suggests the relationship is actually the reverse and only then indirectly. The Fed focusses on the economy rather than the stock market. The Fed generally cares little about the market. The stock market usually leads the economy. The Fed was holding the yield curve flat for a while in hopes of slowing down the economy so as to bring down inflation. Unfortunately, the subprime fiasco caused a downturn, and the Fed began bringing down interest rates on the overnight interbank market. The short end of the yield curve is affected the most and the long end the least. This causes a positive slope in the US Treasury yield curve. The more positive it is the more bullish — after a pause — for the market. The top end used to be the 30-year bond, but when the Fed quit issuing it it was replaced by the 10-year note. Altho the 30-year bond is now being issued again, investors largely ignore it. Sometimes the bottom point is the 3-year note. I always thought of the 3-year note like I do about the 3 dollar currency note. Some people even go into the bill range, which contains debt shorter than 1 year. As to market downside, things are beginning to look grisly. I wouldn’t be surprized if this recession will be significantly worse than the non-recession of 2001. It was a non-recession, because there was no back-to-back 2 quarters of negative growth.
March 8th, 2008 at 2:18 pm
Econ 101
I may be wrong, but isn’t encouraging banks to take advantage of the steepening yield curve urging them to “Borrow short and lend long”? I believe that is what is at the base of the present “credit crunch.” If so, watch out for the whipsaw of a quick reversal to deflation.
March 10th, 2008 at 3:49 am
Beware the game of “Wagging the Dog”! I’ve been on the sidelines for several years, keeping my amunition dry for a time such as this.
Investing during stagflation is most tricky. I’m betting that energy stocks will keep up with or surpass the rate of inflation (which the govern-ment understates). And I maintain “balance” by investing in the only bonds worth investing in during inflationary times;i.e. TIPS.
At least that is how I’m investing my “mad money”. Haven’t made up my mind what to do with the capital I wish to simply “preserve”; since I am in the distribution rather than the acquisition phase of life: retired. And I have enough to “last me” (regardless of inflation) i.e. if I don’t spend it myself!
Simple compounding at the rate of inflation would be the best bet for most retail investors, who haven’t a clue what stagflation is; much less how to invest in times of secular stagflation. Too many don’t remember the decade of the 1970’s … so they are just plum flying blind.
The way I figure it, cash only loses the rate of inflation; whereas stocks lose value and the rate of inflation during stagflation.
March 13th, 2008 at 7:43 pm
Like the chicken and the egg, its not all clear that there is a cause and effect relationship, however it would infer that long term rates should drop substantially before a major rally can get underway.
We are near the completion of a consolidation phase. Like a tightly coiled spring, the market has stored energy and momentum for the long thrust ahead. In the next move up we will exceed the February high of 12,800 in the Dow in a 5-wave move. Afterwards we will drop back to these levels or below one last time, before we blast off.
The pattern is classic Elliott called a Diagonal triangle type II, where waves 1 and 4 overlap and waves 1,3 and 5 are 5-wave structures, like bull moves, while 2, and 4 are 3-wave or a multiple of 3. Wave 4 is complete.
March 13th, 2008 at 7:47 pm
Like the chicken and the egg, its not all clear that there is a cause and effect relationship, however it would infer that long term rates should drop substantially before a major rally can get underway.
We are near the completion of a consolidation phase. Like a tightly coiled spring, the market has stored energy and momentum for the long thrust ahead. In the next move up we will exceed the February high of 12,800 in the Dow in a 5-wave move. Afterwards we will drop back to these levels or below one last time, before we blast off.
The pattern is classic Elliott called a Diagonal triangle type II, where waves 1 and 4 overlap and waves 1,3 and 5 are 5-wave structures, like bull moves, while 2, and 4 are 3-wave or a multiple of 3. Wave 4 is complete.
www.exceptional-bear.com