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Steep yield curve means equities could fly

The steep yield curve could mean good returns for equities

A pretty good predictor of strong stock market returns is the US Treasury yield curve. And right now this signal is bleeping a strong ‘buy’ signal, if you’re not too scared of bear markets to listen.

A yield curve plots the interest rates (yields) on short, medium and long-term interest rates over a particular time period.

With government bonds, the yield curve typically charts the yields on very short-term securities that will mature in a matter of months, through medium term bonds, up to 30-year long bonds.

Due to the time value of money, longer-term bonds normally pay higher interest rates than short maturities, so the curve usually (but not always!) slopes gently upwards as you go further out in time.

Sometimes, however, the yield curve steepens.

Currently short-term Treasury yields are very low, as the Fed has cut rates to stave off recession and the banking collapse.

Ten-year rates are much higher, leading to a steeper chart:

Steep at the price: The Treasury yield curve as of 21st December 2009

Steep at the price: The Treasury yield curve as of 21st December 2009

A measure of the steepness of the yield curve is the gap between two and 10-year Treasury yields. When the former are lower and the latter are higher, you naturally get a steeper graph.

According to this weekend’s Financial Times, the gap between two and ten-year Treasury yields hit 276 basis points (2.76% in humanoid speak) last week.

That’s the highest gap on record, beating:

  • August 2003, when the gap reached 274bp
  • July 1992, when the gap was 268bp

Both of those previous times heralded strong gains for stocks in the years that followed.

In the UK, the gap between the yield on ten-year and two-year gilts also shows the yield curve steepening. Ten-year gilts touched 3.989% on Wednesday last week, their highest yield for two years.

Yield curve risks and rewards

Readers will hopefully nod and mutter agreeable phrases when I say that nothing is guaranteed in investing.

Yield curve steepening has a good record and makes logical sense: lower short-term rates stimulate the economy, while higher longer-term yields show that investors as a group judge it will work.

But these are unusual times. Rates are being kept lower for longer to stave off a banking collapse, rather than because of a normal recession. And other indicators have failed recently, such as the gilt-equity ratio, which seemed to be signaling a cheap stock market in 2008, but was actually flashing up sharp dividend cuts to come.

If you really want to start predicting the future (and I don’t) then in the same issue of the FT, stock market historian David Schwarz says we’re still in a 15-year down market that began in 1999.

Personally, I think the idea that you can time business cycles down to convenient 15-year cycles is a bit of a joke. Broad trends, fine, but I don’t believe shares need to go down again until 2014 to fit Schwarz’ theory.

In fact, if you’re investing for the long-term I think there could still be double digit gains in the stock market per year from here (the huge rally we’ve seen since that article was written means we’ve had much of the fun it predicted already).

As for the yield curve, I doubt we’ve heard the last of it. Readers may recall I think that government bonds are still too expensive, which implies yields have to rise.

If that happens before the Fed has raised its base interest rates by very much, the yield curve could get even steeper!

(Image by: Katuaide)

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{ 8 comments… add one }
  • 1 George December 22, 2009, 4:17 am

    It’s pretty challenging to predict which way the market will go. Butt I think that at some point it is going to go down in a big way. The question is, how do we prepare so that we can make money if we are correct, but don’t get wiped out if we are wrong.

  • 2 Rob Bennett December 22, 2009, 6:19 pm

    I think the idea that you can time business cycles down to convenient 15-year cycles is a bit of a joke. Broad trends, fine, but I don’t believe shares need to go down again until 2014 to fit Schwarz’ theory. In fact, if you’re investing for the long-term I think there could still be double digit gains in the stock market per year from here

    I’ve spent years studying this questions.

    The historical data shows that long-term predictions (properly caveated) always work. But it also shows that you are right to be skeptical of overly precise predictions. We can say today that the odds of a big price drop are far higher than the odds of a big price rise. But we cannot say when the big price drop will come.

    And we cannot rule out a big price rise. Even at times of high prices, we can see big price rises. All that we can say is that it is a long odds bet.

    I wouldn’t even say that a big price rise is a long odds bet in the short term. My view is that it is not possible to say anything about what is going to happen to stocks over the next year or two. There could be a big turn up or a big turn down or a little turn up or a little turn down.

    My take.

    Rob

  • 3 Financial Samurai December 24, 2009, 9:13 pm

    This is a great point which makes me so excited. First the most maligned banks on Wall St. (BOA, Citi, Wells) raise $60 bil from the public, to pay back the public, and now a steep yield curve for them to make BOATLOADS of monay!

    Whooo hooo!

  • 4 The Investor December 26, 2009, 11:01 am

    Yep, and that’s what sticks in the throat for other people FS — the banks gambled recklessly, it blew up, and now they’re being re-hydrated with enormous infusions of cheap money. Leaving aside that though, I agree it’s a big opportunity and people who still think it’s mid-2008 are fighting the last battle; leaving aside regulation risk, the banks are on the mend.

  • 5 The Investor December 26, 2009, 11:05 am

    I wouldn’t even say that a big price rise is a long odds bet in the short term. My view is that it is not possible to say anything about what is going to happen to stocks over the next year or two. There could be a big turn up or a big turn down or a little turn up or a little turn down.

    Agreed, broadly, Rob. People read a lot of patterns into noise, and that’s at the most extreme over short terms. Over longer term the pattern Vs fake pattern argument is more nuanced. I agree clearly it’s better to buy when prices are low than high, and the crucial point you make — that high prices suggest more of a chance of a price drop to come — is of course the one most forgotten by investors who pile in during bull markets.

    As ever the argument boils down to what is high in terms of price. I think investing now is unlikely to produce poor returns on a long term view and possibly even a medium term view. I think P/Es look high, but I expect earnings to explode. Others feel we havent’ seen a cyclical low in P/E ratios, and that today’s P/Es are too high to expect much gain from here.

    That’s what makes a market! 🙂

  • 6 The Investor December 26, 2009, 11:08 am

    @George – The easiest way to do that is to stay mainly in cash. People overcomplicate hedging… personally I think for private investors who are nervous but want equity exposure, over the short term little beats cash savings and say 10-20% in a tracker. For the long-term you wouldn’t want that set-up, but for the long term I wouldn’t want to be bearish on equities.

    I wouldn’t be bearish in the short term either, but that’s the point of the article! Short term is a gamble though, as others have said on this thread.

    Thanks for stopping by.

  • 7 Financial Samurai December 26, 2009, 6:45 pm

    And, guess who raked in $500 MILLION in fees selling $60 bil of their own new stock to investors recently? BOA, ML, and WElls Fargo! Whoo hoo!

    Happy Holidays!

  • 8 Doctor Stock December 27, 2009, 9:08 pm

    1st time here… glad I found you… May it be as you say and we all profit!!!

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