Current Yield Curve Turns Bullish

May 7, 2008: 9:00 AM CST

Although it’s not discussed extensive, the Yield Curve has now normalized to levels that have historically preceded large bullish moves for the overall market. The last time this pattern occurred was in 2003.

Bill Luby at VIX and More recently identified this pattern as well with a good, brief analysis in his post “The Yield Curve looks like May 2003.

Let’s look at the current (and past) Yield Curves and see what may be in the cards for the broader stock market.

Yield Curve Basics

The Yield Curve refers to the different yield values on different fixed income vehicles, specifically the difference (plotted as a line graph) of the 3 Month, 2 Year, 5 Year, 7 Year, 10 Year, 20 Year, and 30 Year yields.

“Normal” Yield Curves form when the 3 month yields are far beneath the 30 year yields (which reflects normalized conditions) meaning you’ll take less income (yield) from a 3-month commitment (such as a CD or short-term T-Bill) than you will with a 30-year commitment (such as a bond). The value of yields increases at each successive type of vehicle.

A “Flat” Curve occurs when there’s little to no difference between short term and long term yeilds.

An “Inverted” Curve occurs when short term yields are higher than long term yields. In this case, it would be to your benefit to lock in your capital for short-term rates (perhaps 3 months to 1 year) at a higher yield than locking it up for 30 years. Also, on the other hand, higher interest rates on loans are more expensive for businesses which cut into profits.

Typically, “Normal” or steep yield curves precede bull markets (as the Fed controls shorter term rates easier than longer term, and lower rates are beneficial for consumers and businesses).

You can learn more about these conditions at a variety of web links, including an explanation from Fidelity Research.

Let’s look at the current “Yield Curve” courtesy StockCharts.com:

Let’s look at the “Yield Curve” in March 2003 and put it into perspective relative to the S&P 500 in 2003:

To flip the perspective, let’s look at two “Inverted” Yield Curves in 2000 and 2007:

Now, let’s look at the most recent “Inverted” Yield Curve which permeated throughout most of 2007 (before the “fall”):

Are bullish times ahead? Uncertain, but the conditions – at least from the yield curve – are more favorable than they were thanks to the Federal Reserve aggressively slashing interest rates to stimulate the economy.

Continue to watch this for more insights and potential clues for the future.

3 Comments

3 Responses to “Current Yield Curve Turns Bullish”

  1. robust Says:

    I think the yield curve is a good metric to watch. But, if you take a look at the yield curve from the bear market 2000-mid 2003, the yield curve was ‘normal’ for a few years. The market bottomed a few months prior to the steepest yield curve, as measured by the ratio of the 3M to the 30Y. What is evident, however, if when looking at a chart of the ratio between the yields, you take note of how violent the change from an inverted flat curve has been to a normal one indicating the substantially more extreme nature of the Fed rate cuts this time around.

  2. robust Says:

    To see it for yourself, here is the ratio during this timeframe: http://stockcharts.com/c-sc/sc?s=$UST3M:$UST30Y&p=W&st=1997-01-01&en=2008-05-06&i=p40456284260&r=9893

    and for 2000-2003:
    http://stockcharts.com/c-sc/sc?s=$UST3M:$UST30Y&p=W&st=1997-01-01&en=2003-09-06&i=t53626789698&r=69

    Interesting is the ratio of the yields is roughly equal during the early 2008 bottom and the 2003 bottom. I wonder if someone has this data going further back…

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