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 [1] 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 [2], 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 [3]:
[4]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 [5], 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 [6] 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 [7], 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 [8] 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 [9], 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 [10])