The bond market has a crystal ball that the equity market should take a look at: the yield curve. The events of this past year have once again proven the value of using the yield curve as a predictor of future economic and financial events. 

For investors that heeded the warnings inherent in the yield curve at the start of last year, they are now sitting on a pot of gold.  For everyone else, well, they are looking at their stocks like a deer at headlights. 

A Yield Curve Primer

Before I go on, let me give you a little primer on the yield curve. For simplicity’s sake, assume that when I say “yield curve” that I am talking about the yield curve for U.S. Treasuries.

The yield curve is basically a chart that plots the yields on bonds carrying different maturities usually ranging from 3 months to 30 years.

When bond investors analyze the yield curve to try to glean its meaning, they look at the difference between yields on short-term securities compared to that of long-term securities.  The spread between the 2-year note and 30-year bonds is commonly used.  A “normal” yield curve is one in which long-term maturities have higher yields than short-term maturities.  In such a case, the yield curve is deemed to have a positive slope.  The curve is considered inverted when long-term maturities have a lower yield than short-term ones.

The shape of the yield curve can mean a variety of things to bond investors but there are two basic ways of looking at it.

First, if it is “positively sloped” this is usually an indication that the Federal Reserve’s monetary policy stance is and will likely continue to be friendly toward the markets.  That is why the yield on short-term maturities is lower longer maturities (the Fed controls short-term interest rates).  A friendly Fed is usually good news to stocks and to the economy.  So a steepening yield curve generally forebodes good times for investors over a several quarter horizon.

On the other hand, a “negatively sloped” yield curve usually indicates that Fed policy is unfriendly, with the Fed engaged in a strategy to slow the economy by raising short-term interest rates.  This, of course, generally portends a gloomier set of conditions for the equity market as well as the economy.  In fact, since 1970 every inverted yield curve has been followed by a period in which S&P 500 earnings growth was negative.

The yield curve is thought to be a better predictor of the economy than the stock market and can therefore give you an edge if you follow it.  Indeed, studies have shown that the yield curve predicts economic events roughly 12 months or more in advance while the stock market is thought to foretell events 6 to 9 months in advance.

The Yield Curve Foretold the Events of 2000

The events of 2000 were forewarned by the inversion of the yield curve at the start of the year in January when it inverted for the first time in about ten years.  While many investors and analysts dismissed the inversion as related to technical factors such as Uncle Sam’s buy-back of the national debt (which entails the purchase of long-dated maturities, mostly), there were clearly other reasons for the inversion that had implications for the markets and the economy.

First of all, the inversion was occurring because the bond market was beginning to believe that the Fed would have to raise rates aggressively to slow the economy.  That’s exactly what happened; the Fed raised rates one full percentage point over the next four months.  In turn, bond investors began to believe that economic growth would decelerate. 

It did.

Stock investors took time to heed the yield curve’s message that the Fed would put its chokehold on the economy but it didn’t take all that long.  It is probably no coincidence that the Dow Jones Industrial Average peaked the same month the yield curve inverted.  The S&P 500 and the Nasdaq peaked just a couple of months later in March.

The Current Situation

So what is this crystal ball telling us now?

For starters, note that the yield curve became positively sloped for the first time in almost a year on December 9, 2000.   The return to a positive slope has a few implications for the markets and the economy.  First and foremost it indicates that the markets expect the Fed to be friendlier toward the markets.  Indeed, the Fed has already turned friendly toward the markets having announced a surprise rate cut on January 3.  Moreover, the bond market is priced for nearly 150 basis points of additional rate cuts this year.

Second, as a result of the expectation for future Fed rate cuts, the bond market believes the economy will regain its footing again after a period of weakening.   This view is reinforced by the notion that the Bush administration will be successful in pushing through a tax cut this year. 

Both the rate cut and tax cut hope also augurs well for the stock market because they typically boost economic growth, thereby boosting corporate earnings.  Lower interest rates, of course, also reduce the competition for capital, as investors flee lower yielding interest rate products and move stocks where returns are usually much higher.

The increased hope for a friendlier Fed is already helping cyclical companies including basic materials companies such as Dupont, International Paper, and Caterpillar.  Retailers and technology companies have also started to gain despite continued weak fundamentals.  All of these companies have one thing in common: hope that the Fed will cut rates and thereby invigorate the expansion and boost corporate profits.

If these hopes are fulfilled, we will be able to look back and say that the yield curve called it.  Again.  The yield curve warned in 2000, "Don't Fight the Fed."  In 2001, that message is being sent again, but with an entirely new meaning.

There are other means by which the bond market can help you to spot key turning points in the stock market and the economy.  I will discuss this in my next lesson. 

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