Another Use For the Yield Curve

Tom McClellan – McClellan Market Report

Last week, I looked at the yield curve as modeled by the spread between the 1-year and 10-year yields on Treasury Notes.  That’s not the entirety of all maturities on the entire curve, but it does give us a simple graphical representation of what the slope of the yield curve looks like.  The two main points of that article were that an inverted yield curve is always bad for the stock market and for the economy, and also to note that just because the yield curve is not inverted, that does not necessarily mean that the stock market is immune to having trouble.

This week’s chart gives us a good insight as to why that is.  For this week’s chart above, I have flipped around the yield spread plot so that we are looking at the 10-year yield minus the 1-year, whereas last week I showed it as the 1-year minus the 10-year.  The result is the same, just upside down.

One other adjustment in this week’s chart is that I have shifted forward that yield spread by 22 months to reveal that the movements of the DJIA seem to follow in the footsteps of this yield spread model.  It is not a perfect fit, just a really good one.

We can see at the left end of the chart that the 1987 peak and crash followed similar movements 22 months earlier in this yield spread.  And the 1990 bear market came on schedule, helped along by Saddam Hussein deciding to invade Kuwait that year.  Later in the 1990s, the relationship got a little bit off track, as the Internet bubble caused stock prices to be skewed higher than was modeled by yields.  But the end of the Internet bubble in 2000 was followed by stock prices working hard to get back on track with what this model showed.

We saw a similar skew during the next bubble, which was in real estate prices during the mid-2000s.  That bubble once again caused the stock market to remain aloft longer than it should have, but then to correct extra hard during 2008 in order to get back on track.  The rise up from the 2009 bottom has been right on schedule according to this 22-month leading indication.

10-1 Treasury yield spread shifted forward 22 months


There are a couple of points about monetary policy which jump out from the realization that the stock market works this way.  The first is that there is a big lag between when the Fed first starts cutting short term rates, and when that move finally has an effect on the stock market.  It is similar to how the release of water from a dam takes some time before water levels rise downstream.

The second point is that the Fed’s current efforts to buy up longer term Treasury and mortgage debt in an effort to stimulate the economy is a misguided policy.  What the Fed is doing is artificially suppressing longer term rates, thereby flattening the yield curve and pushing down this spread.  That’s not what helps the stock market go up, and thus it is not what helps the economy improve.

This next chart takes a longer look at this relationship, looking all the way back to 1955:

10-1 Treasury yield spread, 22 months forward, since 1955

The fascinating point which jumps out from this longer look is that the lead-lag relationship has changed over the decades.  For the current time frame, I needed a 22-month forward offset to get the patterns to line up.  But you can see that the further back in time we go, the more that this 22-month offset seems to be too much.  Back in the 1950s and 1960s, a forward offset of about 12 months worked better.  For some reason, the lag time of interest rate changes having their effect on the stock market has been lengthening.

I am at a loss to provide an econometric reason as to what has changed in the economy to explain such a lengthening.  One would think that with the easier ways we have now to move money around and take advantage of opportunities, that cycles would shrink.  It certainly works that way with fluid flows, like my river analogy above.  If you switch to a lower viscosity fluid, it will flow faster and more readily.  So reducing the viscosity of money should make for shorter lags instead of longer ones, if my thinking is correct.  But the chart shows that my reasoning is not correct in terms of the stock market’s response to interest rate changes.  I’m okay with that, and can just follow what the chart says instead of what my mind thinks it should do.

Looking ahead, the flattening of the yield curve during the past 2 years (thanks, Dr. Bernanke!) means that stock prices will be under downward pressure.


Related Charts

Dec 20, 2012small chart
Steep Yield Curve Does Not Offer Complete Immunity
Oct 12, 2012small chart
40-year Cycle In DJIA
Jun 29, 2012small chart
Interest Rate Models Call For Lower Dollar

Chart In Focus Archive


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McClellan Financial

The McClellan Market Report and its companion Daily Edition are produced by Sherman McClellan and Tom McClellan. Both are technical analysts and educators whose innovative insights have helped countless investors succeed. The McClellans' work has been repeatedly quoted in Barron's, and their market timing signals have ranked them in the top ten timers for both intermediate and long term by Timer Digest.

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  • Mr. Market

    Why shift the yield curve forward 22 months ?

    The yield curve steepens in a “recession” and the yieldcurve flattens in a strong(er) economy. Currently the yield curve is distorted because of the (very) low short term rates.

    There’s another weird thing. The yieldcurve (5 year yield vs. 30 yield curve) seems to have started to flatten. Too early to call whether this is the first sign of an economic recovery. Currently I am still (besides Mr. Market) Mr. Bear.

  • rp1

    “I am at a loss to provide an econometric reason as to what has changed in the economy to explain such a lengthening.”

    Higher debt. If a business, household, or government is servicing higher debt, it may be slower to respond to changes in rates.

  • Alberto

    Private amd public debtors need prolonged very low interest rates, well below inflation. For debtors short rates are meaningless, they watch long term rates and must be reasonably sure that rates stay low for a large portion of their debt duration. This is the reason of the FED policy, the fact the market thinks that the FED is working to prop stocks up is a misuranderstanding because this is a short time side effect and not the goal of the ZIRP.

  • Drew

    The yield curve steepens during recessions? Maybe it’s too early in the morning and I haven’t had enough coffee, but the charts above clearly show the exact opposite, which makes more sense.

  • Andrew P

    Wait a minute. Yield curves almost always invert going into recessions. Strong economies make long rates go up.

  • Drew

    My bad, you’re correct. I got the yield curve ratio numbers backwards.

  • Brent

    Am I crazy or do the charts seem to show, — typically (not always) — a rising — not falling — stock market following a flattening curve, UNTIL the curve turns negative – which would lead to the opposite conclusion of the author because that has not happened?

    Also, the reason, in theory, that the flattening curve should precede a depressed market is that the flattening curve means the bond market expects slower growth. In this case, since the flattening is caused intentionally from fed actions and not bond buyers and sellers, there would be no significance to it at all.

  • Mr. Market

    No, an inverted curve occurs in a (very) strong economy. (think 2005-2007)

    No, a strong economy makes short (!!) term rates go up. It’s NOT done by the FED.

  • Mr. Market

    Did the readers notice that the 3 month T-bill rate has crashed in the last days ? This is a sign of investors fleeing the stockmarkets. As a result of the looming “fiscal cliff” ?

  • flow5

    “The first is that there is a big lag between when the Fed first starts cutting short term rates, and when that move finally has an effect on the stock market”

    The money supply can never be managed by any attempt to control the cost of credit.

  • flow5

    “For some reason, the lag time of interest rate changes having their effect on the stock market has been lengthening”

    The commercial banks used to store their liquidity – now they buy their liquidity (Reg Q ceilings were eliminated). This is real stupid (from a macro point) because the lending capacity of the system is determined by monetary policy – not the savings practices of the public. The individual banks compete for each other’s deposits, but as a domestic system, they gain nothing but higher interest expenses (if the Fed remains tight). The individual CBs are less profitable as a result (other things equal). The payment of interest on excess reserve balances exacerbates this problem (further extending the lag effect of rates).

    Interest is the price of obtaining loan funds, not the price of money. The price of money is the inverse of the price level. If the price of goods and services rises, the “price” of money falls. Interest rates in any given market at any given time are the result of the interaction of all the forces operating through the supply of and the demand for, loan funds. I.e., Keynes liquidity preference curve is a false doctrine.

  • flow5

    “Did the readers notice that the 3 month T-bill rate has crashed in the last days”

    The expanded FDIC insurance coverage ends. When the Fed & FDIC expanded its coverage this induced dis-intermediation (where the size of the non-banks shrink, but the size of the CB system remains the same) – very stupid & just like the payment of interest on excess reserve balances. Now this is being reversed. As it is reversed the supply of loan-funds will increase (& velocity) – depressing rates. Buy gold & stocks (before legislators compromise on the budget).