The Yield Curve - A Multi-Talented Indicator
Indicators come in two styles. Ones that are backed by money and ones that aren't. Sure, surveys can be helpful in gauging investor sentiment. But there's no better way to measure someone's expectations then by looking at what they're willing to pay for an investment.
If that's so, then U.S. Government bonds stand alone in the number of votes they collect. Over $450 billion of the $3.5 trillion U.S. Treasury market changes hands each day, according to the New York Federal Reserve. Each time they do a new forecast is born, and they have proved to be quite dependable.
To read bond investor's expectations, first find the slope of the yield curve. Subtract the yield of the U.S. Treasury's three-month bill from its 10-year note. The curve has generally sloped upward, because investors demand higher yields on longer bonds to compensate themselves for the risk of inflation. Over the past 50 years, the 10-year note has yielded an average of 120 basis points more than the three-month bill. But there have been extremes.
In the early 1980's the short-term rate rocketed 370 basis points higher than the 10-year note as the Federal Reserve aggressively raised short-term interest rates to land its final blows against the 1970's runaway inflation. In 1992, long rates were 370 basis points above short rates, as the outlook improved for an economic rebound.
The difference between these two yields (or the yields of other bonds along the maturity spectrum) sheds light on investor's expectations. A 1996 paper by two Federal Reserve Bank of New York researchers found that the spread between the three-month Treasury bill and the 10-Year note was an effective predictor of U.S. recessions 1 . In fact, when forecasting a recession six months in advance it was the best indicator the researchers tested. For more indicators of an oncoming recession, see A Brief Primer on Economics.
How the two rates differ determines the probability of a slowdown. When they are at about the same level, there is only a 25 percent chance of a recession. When the Treasury bill is 82 basis points above the 10-year note, creating an inverted yield curve, there's a 50 percent chance of a slowdown. When the curve is inverted by more than 200 basis points, you can be nearly 90 percent sure that slower times are ahead.
It didn't take too long for researchers to figure out that if the yield curve was an effective predictor of economic recessions, then it might have something to say about the stock market. The results of a study published last year found that the slope of the yield curve helped forecast a drop in stock prices 2 . The researchers found that if the curve was flat, there was about a 35 percent probability of a bear market. When the Treasury bill was 83 basis points above the 10-year note, there was a 50 percent probability of a bear market.
The most recent test of both of these studies came at the end of 2000, when the yields on short rates rose 50 basis points higher than those on 10-year notes. The curve proved its prescience. The first economic recession in 10 years was about to hit and stocks had just begun a two and a half year slide.1 Arturo Estrella and Frederic S. Mishkin, “The Yield Curve as a Predictor of U.S. Recessions,” Current Issues in Economics and Finance , June 1996.
2 Bruce G. Resnick and Gary L. Shoesmith, “Using the Yield Curve to Time the Stock Market,” Financial Analysts Journal , May/June 2002.
William Hester, CFA