There’s an old song that says “money makes the world go around…”
It ain’t wrong.
Among other things, money is a yardstick of both economic growth and growth expectations. And being able to track its price, like the price of any other asset or commodity, will give you insight into the expected strength or weakness of the economy.
Interest rates are the “price” of money. And the yield curve is a chart of the expected price of money today and into the future.
But how can you use the yield curve as a predictive tool?
That’s what we’re going to talk about today.
Tracking the Trend of the Yield Curve
Like I mentioned in your last letter, looking at the shape of the curve across all yields is basically a snapshot in time. (Like the featured image at the top of this post.)
But for it to have some kind of predictive usefulness, you have to be able to see how the shape of the yield curve is trending: Where it was 6 months ago versus where it is today. And which way it’s heading.
To get this kind of perspective, Wall Street typically looks at the spread between the long and short end of the curve. Most typically they’ll look at the spread between the 10-year and 2-year Treasury Notes.
Now if you want to see the predictive ability of the yield curve in action, let’s look at it during the last two major economic recessions this century…
Throughout the 1990s, the “10-2 spread” trended lower indicating a “flattening” yield curve. The spread between the yields tightened to half a percent for most of 1998 and 1999. In early February 2000, however, the yield curve flipped and the 10-2 spread went negative (the curve inverted).
This is what followed in the stock market and the economy (the recession is indicated in grey):
Stocks in the S&P 500 gave up 49% and the economy entered a recession for the better part of 2001.
Now let’s look at the last economic disaster better known as the “Great Recession.”
Once the market and economy recovered from the Tech Bubble, the yield curve (again, the 10-2 spread) steepened or normalized into August of 2003. From there, however, it started to flatten again, going negative (inverting) in January 2006.
With a couple brief exceptions of tipping back into positive territory, it stayed negative for a year and a half. Take a look:
A little over a year later, stocks put in a top that gave up 54% of the market’s value and plunged the economy into a recession lasting a year and a half.
So How Does This Magic Work?
It’s a bit like the difference between betting in Las Vegas versus betting at Churchill Downs.
When you gamble at most tables in Las Vegas, it’s you against the house and the odds are pretty much fixed, ever so slightly, against you.
But… head to Churchill Downs or any other racetrack, and it’s a different type of betting. “Parimutuel” betting is you betting against the other bettors in the race. The odds of the horses will move up and down depending on how much money is bet on any horse relative to the total money in the pool. By watching the odds move as you get closer to post time, you can effectively get an idea of which horse the “smart money” likes.
The yield curve gives you the same basic insight.
When you watch the yield curve, you’re seeing the entire market putting its money where its mouth is. As uncertainty about the future builds — for whatever reason — money rushes into what has always been considered the safe haven of long bonds (today the 10-year T-Note is the benchmark) which pushes yields lower.
When you have the entire market signaling uncertainty, it’s a pretty good sign that trouble may be coming.
Of course the Fed plays in this sandbox too, trying as mightily as it can to influence the perceptions of the market.
We’ll talk about the different ways they try to manipulate the market in your next issue.
Make the trend your friend,
Editor, Streetlight Daily