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Chart In Focus

Another Use For the Yield Curve

Chart In Focus
December 27, 2012

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.

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. 


Tom McClellan
Editor, The McClellan Market Report

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