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July 01, 2004

The Yield Curve: Its Not Bearish But The Trend Has Changed
by Guy Lerner

There are some pretty cool indicators out there. But one of the most useful and most simple is the slope of the yield curve. The slope of the yield curve is generally constructed by taking the yield on a long term bond like the 30 year minus the yield on a short term Treasury bill like the 3 month. The difference between a 10 year note and a 1 year will suffice as well. Despite how it is constructed the following key points are essential for investors to understand:

• an up sloping yield curve portends that the Federal Reserve's policy is likely to be accommodative towards the markets and economic strength should follow

• a down sloping yield curve is indicative of a Federal Reserve attempting to slow the economy by raising short term interest rates; this does not bode well for the markets

• a flat or inverted yield curve -where short term rates are greater than long term rates- may signal a coming recession

The yield curve has been shown to be an excellent predictor of the economy. Much attention in economic and financial journals (see reference below) has been devoted to the yield curve and its ability to predict the probability of a recession. This is a simple yet powerful indicator.

The calculation that I use is the yield on the 30 year Treasury bond divided by the yield on the short term 3 month Treasury bill. Figure #1 shows this indicator (middle panel) on a weekly time frame with a price chart of the S&P500 in the top plate. The current ratio is the highest in almost 50 years!

Figure #1: S&P500 (weekly)/ yield curve ratio (1992 to present)

Yet we kind of knew this because the Federal Reserve embarked on an aggressive campaign starting in 2001 to lower short term interest rates to stimulate the failing economy. After 13 rate cuts, short term interest rates were at 50 year lows. With inflation non-existent, yields on long term bonds remained low as well. Thus, the very steep yield curve and very high ratio between long and short term yields. Yes, this is yesterday's news.

More importantly as we try to figure out what lies ahead, look at the broken trend line in figure#1 (label 11) - the trend of the up sloping yield ratio curve has been broken. Is this good? The ratio yield curve is still above one and indicates favorable conditions for the stock market. Or does the broken trend line indicate a change in trend for the yield curve and more importantly, what effect will this have on the stock market?

As a stand alone indicator for investing, utilizing the ratio between the long term and short term yield is pretty effective. The bullish mode is when this ratio is greater than 1.15 (positive slope), and the indicator becomes bearish (negative slope) when the ratio is less than 1. Table 1 shows the results of a simple trading system that goes long the market when this indicator is in bullish and bearish modes.

While we can refine the bullish mode with more efficient entries and exits to minimize the greater than 20% plus draw downs to our account, it should be clear we do not want to be long the stock market when the yield curve is flat or inverted- ie, when our ratio is less than 1. When in bearish mode, you do not make money.

Yet the problem as I see it is that the indicator has broken a long term (3 year) trend line that started when the yield curve was inverted (see figure #1). The indicator is a long way from being bearish but the up trend is broken. The question I want to know is how does a change in trend in the slope of the yield curve ratio effect the stock market?

As most of you know who have been reading my letters for a while, I generally try to construct a method to capture the trend and then test this concept out using the computer. In this case, I am just going to visually examine the yield curve for trend line breaks similar to the current scenario. Our rules for constructing a trend line are as follows: the trend line will start from a cyclical low (less than 1.15) in the yield curve, and its ascent will capture at least two points of the data.

In 50 years of data, there have been 11 trend line breaks in the yield curve ratio including the most recent occurrence. Each occurrence is labeled 1-11 on the accompanying charts. (Note: label 4 is not shown, and occurrences 9- 11 are in Figure #1.)

Figure #2: S&P500 (weekly)/ yield curve ratio (1976 to 1990)

Figure #3: S&P500 (weekly)/ yield curve ratio (1960-1973)

So what does the initial trend line break mean for prices? Out of the 10 previous occurrences, there was only one time that prices went immediately higher, and this was in October, 1985 (see label #8, figure #2 ). This lead to a greater than 50% plus gains in the S&P500 over two years leading up to the 1987 crash. Interestingly, despite the change in trend in the yield curve, short term interest rates continued to track lower (i.e., increasing Fed accommodation) throughout this period. The other 9 times where the trend in the yield curve was broken generally saw sharp sells offs (6 instances) or backing and filling in prices. The market had a difficult time moving higher.

But looking at the trend line breaks a bit more closely shows that the indicator did not have to cycle lower and become bearish before prices moved higher. Or put another way, prices could move higher even though the trend in the yield curve was down and the indicator was still in bullish mode (i.e., above 1.15). Although the exception, this occurred in scenarios labeled with numbers: 1, 8, and 9. In all three of these occurrences, prices headed significantly higher as short term rates stabilized or headed lower.

These instances are indicated by the ovals on the bottom panels of the figures which highlight short term interest rates.

So what is TheTechnicalTake? It appears that a trend line break of the ratio yield curve is a significant event. In 90% of the previous occurrences the stock market had a difficult time moving immediately higher. A sharp sell-off occurred 60% of the time. Following the trend line break, the indicator became bearish 70% of the time before prices headed higher. In the other 3 instances where there was a trend line break but the indicator remained in bullish mode (scenarios 1, 8,9), prices only started to head higher once short term interest rates stabilized or headed lower.

So how should we play the current scenario? First, it should be obvious that the current environment is very precarious. But there always is uncertainty in the markets so why is this time different? Well because being in sync with the yield curve is so important- that is why this time is different. This indicator is that good. Yes the market could go higher and my accounts are actually positioned that way. {Note: these were trades that were put on several weeks ago when the market sold off hard in response to rising interest rates and sentiment was significantly more bearish, and my expectation is that these trades should liquidate soon.} With sentiment becoming more bullish and with prices near their upper ranges, I don't think now is the time to be putting on the big kahuna. I think the more prudent approach would be to monitor short term interest rates and if these stabilize or head lower, then prices in the stock market have a chance to go higher.

With interest rates so low right now what is the possibility that they will go lower? I don't have the answer to that question. But looking at scenarios 8 and 9 where prices headed higher despite the trend line break in the yield curve, short term yields were actually above 5% so there was some room for the Fed to be accommodative. Thus the markets zoomed higher. In scenario 1, short term rates, which were less than 3%, stabilized only after a very nasty sell off.

That is The Technical Take!

The Technical Take
$ break in trend of yield curve ratio generally does not lead to higher prices
$ break in trend of yield curve ratio leads to sharp sell off 60% of time
$ break in trend of yield curve ratio may lead to higher prices once short term interest rates stabilized
$ short term rates already at historic lows

Thanks for reading and I hope you have found my analysis informative, insightful and profitable....

If you would like more information regarding my methodologies, please contact me at blueguyzee@yahoo.com.

Reference: Michael J. Dueker, "Strengthening the Case for the Yield Curve as a Predictor of U.S. Recessions", Federal Reserve Bank of St. Louis; article may be obtained at the following link: http://research.stlouisfed.org/publications/review/97/03/9703md.pdf

Guy M. Lerner
http://thetechnicaltakedotcom.blogspot.com/

Disclaimer: Guy M. Lerner is the editor and founder of The Technical Take blog. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. Under no circumstances does the information in his columns represent a recommendation to buy or sell stocks. Lerner may on occasion hold positions in the securities mentioned in his columns and on the Web site; in all instances, all positions are fully disclosed at http://thetechnicaltakedotcom.blogspot.com/. However, their positions may change at anytime. For more information on any of the above, please review The Technical Take's full Terms of Use and Privacy Policy (link below). While Lerner cannot provide investment advice or recommendations, he invites you to send your comments to: guy@thetechnicaltake.com.

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