Picture du Jour: Yield curve points the way for stocks
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.
The first of the “Picture du Jour” stories follows below.
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.
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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