What Good Is The Yield Curve?
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It is amazing to think of this now in 2009, but back in February 2007 Ben Bernanke said something totally amazing. Appearing before the Senate Banking Committee, Bernanke said that the then inverted yield curve (short term rates higher than long term rates) was not a very big problem. He did not see the inversion as putting the banking sector "under tremendous pressure", noting that many banks could use hedges to deal with this risk. Larger banks, he said, were more protected from the problem. He went on to state that, "If you look at other measures of financial markets such as corporate bond spreads, you do not see anything that suggests anticipations of future stress." (see page 29 of Bernanke's testimony)
My guess is that the accuracy of that prediction did not weigh heavily in the decision to reappoint Bernanke to another term as Fed chairman.
The yield curve has a well deserved reputation as an economic indicator, with an inverted yield curve forecasting an economic slowdown. But it also has another neat trick: it can tell us ahead of time whether small cap stocks or large caps will outperform.
This week's chart takes a look at this phenomenon. Playing the part of the entire yield curve will be just two components, the 10-year and 3-month Treasury yields. The upper line in the chart shows the difference between these two yields. Also on the chart is a relative strength line for the small cap Russell 2000 Index versus its big cap brother the Russell 1000. The yield spread has been shifted forward by 15 months to reveal how it gives a leading indication for where the relative strength line is going.
As with all leading indications, this one is not perfect. There was a notable spike that was not on the agenda at the end of 1999, when the Fed's money pumping to ward off the Y2K problem pushed a lot of money into small cap stocks for just a brief time. The relative strength line also did not respond as prescribed in 2001-02. That dip in the yield spread came because of the Fed's effort to fight the invisible inflation that was thought to lie "over the horizon".
Generally, though, the yield spread does give a good leading indication of small cap outperformance or underperformance. Right now, we are still in the period when the Fed's rapid rate-cutting effort in 2008 should be bringing us better relative performance for small caps. That should last into 2010. At the point when short term rates are once again allowed to rise, and this yield spread turns downward, we can mark our calendars to expect a similar downturn for small cap outperformance about 15 months later.
Editor, The McClellan Market Report
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