Yield Curve vs. S&P 500 - Which One Should We Believe?

By: Paul Kasriel | Wed, Dec 7, 2005
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Both the shape of the yield curve and the behavior of the S&P 500 stock index are components of the Conference Board's index of Leading Economic Indicators. In the third quarter, these two indicators sent divergent signals. The S&P 500 increased at an annualized rate of 15.2%; the spread between the yield on the Treasury 10-year security and the fed funds rate narrowed by 46 basis points to 0.75%. The behavior of the S&P 500 signals stronger economic growth ahead; the behavior of the yield spread signals weaker economic growth ahead. On which one does history suggest we should "place our money?" The two charts below say put your money on the yield spread's prediction.

What I have done is find the highest correlation between the quarter-to-quarter percent change in real GDP and lagged values of the percent change in the S&P 500 and lagged values of the level of the yield spread. As the charts show, the two-quarter lag of the yield spread has a correlation of 0.40 with real GDP growth, beating out the one-quarter lag of the S&P 500 by 4 basis points.

Chart 1

Chart 2

Now, a higher correlation by only 4 basis points is not a lot to hang your hat on. But notice that the yield spread leads real GDP growth by two quarters whereas the change in the S&P 500 leads by only one quarter. This suggests that the yield spread might even be a bit of a predictor of the behavior of the S&P 500. Moreover, as Charts 3 and 4 show, the S&P 500 gives more false "recession" signals than does the yield spread. (The shaded regions in Charts 3 and 4 denote recessions in the US.) Lastly, Fed Chairman Greenspan disparages the usefulness of the yield spread as a leading indicator. I have found Greenspan to be a pretty reliable contra-indicator throughout his professional career.

Chart 3

Chart 4


Paul Kasriel

Author: Paul Kasriel

Paul L. Kasriel
Director of Economic Research
The Northern Trust Company
Economic Research Department
Positive Economic Commentary
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675

Paul Kasriel

Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul's 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst. Through written commentaries containing his straightforward and often nonconsensus analysis of economic and financial market issues, Paul has developed a loyal following in the financial community. The Northern's economic website was listed as one of the top ten most interesting by The Wall Street Journal. Paul is the co-author of a book entitled Seven Indicators That Move Markets.

Paul began his career as a research economist at the Federal Reserve Bank of Chicago. He has taught courses in finance at the DePaul University Kellstadt Graduate School of Business and at the Northwestern University Kellogg Graduate School of Management. Paul serves on the Economic Advisory Committee of the American Bankers Association.

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