What is the Yield Curve telling us about the future? http://ww1.dowtheoryletters.com/

What is the Yield Curve telling us about the future? http://ww1.dowtheoryletters.com/

October 28, 2013 Good Reads 0 Comments

October 25, 2013 — “With all this consumer debt, business debt, government debt, smaller movements in interest rates have a magnified effect … a small movement can tip the boat.” Bill Gross
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Matt’s Market Insights

What is the Yield Curve telling us about the future?

With interest rates front and center these days, I thought we would take some time to explore the yield curve and some of the information that can be gleaned from it. The yield curve represents the relationship between interest rates on bonds of different maturities, but equal credit quality. For our purposes, we’ll be discussing the US Treasury yield curve.

The slope of the yield curve has proven to be a good forecaster of economic growth. There are three basic shapes the yield curve can take, each with different implications regarding economic growth. We’ll explore these below and then take a look at the what the current yield curve is saying.

A normal, upward sloping yield curve is shown below. This is how the yield curve looks when an economy is growing and investors are confident. In a growing economy, investors demand additional premium (yield) for longer maturity bonds. This is logical considering there is more risk associated with having money tied up for longer periods of time. Healthy economies nearly always have an upward sloping yield curve, although the interest rates that make up that curve may differ substantially from one period to another.

A flat yield curve indicates that investors are not being compensated for the additional risk of longer maturity bonds. This is a warning sign that an economy is under duress; investors expect slow growth, and economic indicators are sending mixed signals. As investors buy and sell bonds to flatten the yield curve, they are demonstrating through their behavior that they are worried about the outlook of the economy. As a result, they prefer to have their money tied up longer in safe investments, and demand less of a return for doing so.

A flat yield curve can develop into the dreaded “inverted” yield curve when the economic outlook is very bleak. When the yield curve inverts, it indicates tough economic times ahead. The logic goes like this: If I’m worried the economy is going to crash, I want to look for safe ways of preserving my capital. If I suspect falling equity prices, and falling interest rates, I’m going to try to lock my capital away in longer-term bonds as a way to ride out the storm. As more and more investors do this, it drives longer maturity bond prices up, and the yields down. These same investors will shy away from short-term bonds, which may have to be reinvested during the downturn. This lack of demand drives short-term treasury prices down and the yields up.

There are multiple ways to analyze the slope of the yield curve, so which is the most accurate? Statistically, the method that has shown the most reliability in predicting future economic growth has been to look at the difference between the rates on the 10-year Treasury Note and the 3-Month Treasury Bill. When the yield on the 10-year is greater than the yield on the 3-Month, the slope is positive, and when this relationship reverses (3-Month rate greater than the 10-Year rate), the slope is negative and the yield curve is considered inverted.

Historical observations using this method show that an inverted yield curve indicates a recession approximately one year away. Inverted yield curves have preceded each one of the last seven recessions, as can be seen on the chart below.

This chart contains a wealth of information, so let’s study it carefully. On the chart, the brown line represents the measure of slope we just discussed (the difference between yields on the 10-Year Treasury Note and the 3-Month Treasury Bill), going back to 1953. Each time this brown line drops below zero, the yield curve is considered to be inverted. Notice that this occurs immediately preceding the last seven gray vertical bars — which indicate recessions as defined by the Bureau of Economic Analysis.

The blue line shows GDP growth, and for the purposes of this chart, the GDP figures have been shown with a lag of one year. Looking at the chart with this lag allows us to see how closely correlated an inverted yield curve is with a drop in GDP one year out.

https://www.clevelandfed.org/research/data/yield_curve/2013/1013/image2.gif

The last time the yield curve inverted was in August 2006; it provided advance warning for the recession that “officially” began in December 2007. Before that, the yield curve inverted in April 2000, predicting the 2001 recession. The only time this indicator gave a false signal was in 1966.

I’m guessing some of you are wondering whether this relationship will still hold in light of the massive amounts of quantitative easing. If I had to venture a guess I would say yes, and here’s why. First, the FED can generally control short-term rates, but has much less effect on long-term rates, which are typically set by the market. Second, even the FED’s control of short-term rates is not perfect, as evidenced by the spike in short-term Treasuries earlier this month during the debt crisis.

So what is the yield curve saying now? The 10-Year Treasury is currently at about 2.5% and the 3-Month Treasury is at 0.036%, making the difference roughly 2.46% — positive by a good margin. So the shape of the yield curve is telling us that bond investors expect the economy to grow, albeit slowly.
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Richard’s Remarks

And the little locomotive huffed and puffed and seemed to be running out of steam. With so many unsettled business items, the stock market seems to be puzzled, both on the bear side and the bull side. In the meantime, gold is trading flat but happily above its huge base. For my subscribers and I, it makes more sense to watch the market than attempt to beat it. I’ve almost given up reading the newspapers since there are so many cross-currents in the news. And I can’t make anything bullish or bearish out of it. 

However, as long as the Fed continues QE forever, its obvious that the bears are having a hard time. Advice — sit tight with your gold and enjoy the circus from a distance. 

As far as the efforts to lift the debt ceiling, the odds of either party failing to lift the debt ceiling would be almost a revolutionary step. One way or another the debt ceiling will be raised or pushed out further. Actually the very concept of a debt ceiling is absurd. The ceiling will continue higher despite the antics of both parties.
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One of the most fascinating battles in history is occurring. It’s the battle between Walmart and Amazon. Amazon is now going into the grocery business and aiming for same day delivery. Actually same day delivery is becoming the new trend. Yesterday I ordered a package from Time Warner. Amazingly it was delivered the next day. Amazon wants to be the ultimate retailer, they are building huge warehouses all over the country. I’m wondering whether this will put extreme pressure on supermarkets. Keep your eye on Walmart stock. An interesting ratio will now be Walmart in terms of Amazon.




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