A Look at the Yield Curve at Market Tops and Bottoms

Dec 27, 2009: 7:34 PM CST

According to CNBC, the Yield Curve has reached its steepest curve ever.  CNBC Producer Lee Brodie writes, “the spread between yields on two-year notes and 10-year notes widened on Monday to its steepest level on record.  Specifically, the spread between the yields pushed out to 280 basis points on Monday from 274 basis points late last week.”

Let’s take a quick look at the current “Yield Curve” courtesy of StockCharts.com’s “Dynamic Yield Curve Tool” and then compare this curve to the market peak in 2007 and the market bottom in 2003 – you might be surprised.

Remember, the Federal Reserve can ‘set’ short-term rates by altering overnight interest rates, but the economy generally sets the yield at the longer end of the curve, such as the 20 and 30 year yields, which are much less volatile than 3-month or 1-year rates.

Let’s start now with the current graph of the yield curve (December 2009), which compares short-term, intermediate term, and long term treasury yield rates.

StockCharts data shows the 3-month, 2-year, 5-year, 7-year, 10-year, 20-year and finally 30-year Treasury Yields.

The black line is the current yield curve while the green ‘shadow’ shows the recent movement over the last few months of the curve.

To the right, we can see the S&P 500 index and compare.  The tool is actually a ‘dynamic’ tool where you can slide your cursor over the S&P 500 and track changes to the Yield Curve – it’s a really neat tool!

Like in March 2009 (S&P 500 bottom), the yield curve was ‘normal,’ meaning short-term yields were much lower than long-term yields – almost identical looking to the current curve because short-term rates remain unchanged (though longer-term rates are rising slightly).

What does this mean?  Actually, to answer this question, let’s step back in time 5-years to see the last period where the yield curve looked like this.

Normal yield curves are associated with (or correlated with) Stock Market bottoms (in recent history).  Lower interest rates spur investment in the economy, which helps the economy grow.

Higher interest rates hurt or discourage investment, which can lead to an economic slow-down (as companies are either unwilling to borrow debt at higher yields, or the higher yields cut into what otherwise would be profits for the company).

My point in this post is to show the recent position of the Yield Curve now, at the 2007 peak, and at the 2003 market bottom instead of explaining how rates affect the stock market – that is for another day!

Speaking of the peak in 2007, let’s look at the other side the the equation – a few months prior to the absolute October peak in the S&P 500 – this is the yield curve as of March 2007 – when the curve was “Inverted”

An inverted yield curve occurs when the Federal Reserve raises short-term rates to a higher level than 30-year rates, or specifically when short-term rates – such as 3 month bills – have a higher yield than 30-year bonds.

Inverted yield curves are associated with market peaks.  The Federal Reserve began cutting interest rates a few months prior to the October peak, so one cannot use the yield curve specifically as a ‘timing’ mechanism.

The Yield Curve was inverted also in 2000 prior to the stock market peak – though this particular tool does not show data from that period.

Let’s take a final look at the prior stock market bottom – this chart shows the February/March 2003 position of the yield curve… and subsequently the final low of a ‘triple bottom’ pattern prior to the 5-year bull market that ended with 2007’s “inverted” yield curve.

And now?

Again, normal yield curves are associated with rising stock markets – as we see currently.  The Fed will begin raising rates when it feels the economy can withstand the higher short-term yields, which means that the economy would be moving forward and growing.

It would appear that the stock market is looking ahead for that possibility by rallying so sharply in 2009.

Take some time to study this topic in more detail – you’ll find some interesting insights.

For a bit more reading, see my prior posts:

February 18, 2008Is Fed Easing Actually Good for the Market?

February 19, 2008A Look at Bonds, Stocks, and the Fed Rate Cut

Corey Rosenbloom, CMT
Afraid to Trade.com

Follow Corey on Twitter:  http://twitter.com/afraidtotrade

3 Comments

3 Responses to “A Look at the Yield Curve at Market Tops and Bottoms”

  1. Bob Says:

    Interesting observations. I don't know how much significance one should now place on historic yield curve shapes as compared with current shapes. The Fed has taken extra ordinary measures to stimulate borrowing and as such the short end of the curve is at essentially zero. In addition, the U.S. Treasury has taken up the cause too; buying Treasuries and artificially hold longer term interest rates down; the effect is added liquidity and lower long term borrowing rates. Help for the troubled home refinancing sector of the economy. These actions are distorting the yield curve. Without such actions, we would certainly be seeing a flatter curve, if not inverted.

    Also, one might argue,… with the yield curve so steep, the Fed now has some room to maneuver. A bump in short term interest rates would put the yield curve back into a more normalized shape.

  2. Bob Says:

    Interesting observations. I don't know how much significance one should now place on historic yield curve shapes as compared with current shapes. The Fed has taken extra ordinary measures to stimulate borrowing and as such the short end of the curve is at essentially zero. In addition, the U.S. Treasury has taken up the cause too; buying Treasuries and artificially hold longer term interest rates down; the effect is added liquidity and lower long term borrowing rates. Help for the troubled home refinancing sector of the economy. These actions are distorting the yield curve. Without such actions, we would certainly be seeing a flatter curve, if not inverted.

    Also, one might argue,… with the yield curve so steep, the Fed now has some room to maneuver. A bump in short term interest rates would put the yield curve back into a more normalized shape.

  3. Using Yield Curve To Gauge The Economy Cycle Says:

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