Inverted Yield Curve Observations

Feb 6, 2008: 10:42 AM CST

StockCharts.com has a wonderful tool for evaluating the relation between the interest rates (yields) and the stock market (S&P) in the Dynamic Yield Curve page.

Using this tool, you can compare 3 month yields with 2 year, 5 year, 7 year, 10, 20, and 30 year treasury yields and see not only what effect the Federal Reserve has had on interest rates (yields), but also what the response in the stock market was during periods of flat, inverted, or normal yield curves.

There is an explanation on the site, but let’s take a quick look at the past and the present.

This was the condition of the yield curve and the S&P on September 1st, 2000. Look at the clear inversion of rates.

The 3 month yield (on left of blue chart) is clearly the highest yielding rate and the 10 and 30 year rates (yields) are the lowest yielding.

This means that you can get a better rate of return on your money by buying a 3 month vehicle than you could committing your money into a 30 year bond. Shouldn’t you get a higher rate the longer you commit your capital? Yes, and that’s why the situation is considered “inverted.”

This indicates that the Federal Reserve may have raised rates above the normal rate that the economy expects and that capital is difficult to obtain (because of high rates – it works both ways) and that an economic contraction may be near.

In fact, 2000 and 2001 did start the recession until 2003, and the inverted yield curve forecast this development (although it could not forecast the economic devastation caused by the September 11th attacks, of course).

Now, let’s look at the bottom of the market, as a result of the Federal Reserve lowering interest rates down to 1%.

On April 1st, 2003, we see the bottom of the S&P 500 corresponds nicely with extremely low interest rates (yields) and also with a normal yield curve.

Normal means that you receive less interest on a 3 month treasury vehicle than you would a 30 year bond, or that companies can borrow cash at lower rates for shorter term projects. This represents expansionary monetary policy, and marks a great environment for economic expansion.

Finally, what happened just before the recent stock market decline of 2008? If you guessed an inverted yield curve, you guessed correctly:

Actually, the yield curve inversion occurred as 2007 was about to begin, which confused many economists and traders, as they began expecting a sharp stock market decline as a result of this inversion. 2007 saw prices appreciate and make new highs until October and November 2007 when prices began their steep declines into 2008.

Will we experience the same conditions of 2000 as the yield curve forecasts? Probably not, because the Federal Reserve has been ever vigilant at reducing interest rates even at the cause of sparking new inflation. Let’s see where we are as of yesterday on the charts:

Notice that the yield curve is now normal, and resembles conditions that could be expected at market bottoms. Just like inverted curves do not immediately precede market tops, normal curves do not immediately precede market bottoms. The effect of the cuts must sink in to all sectors of the economy and business conditions must then favor expansion and borrowing, which hasn’t happened as much as needed yet.

Nevertheless, the StockCharts.com Dynamic Yield Inversion tool is a fun gadget to study and learn more about how interest rates affect the economy and stock market.

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4 Comments

4 Responses to “Inverted Yield Curve Observations”

  1. Justin Says:

    Cool. That’s the best explanation I’ve seen of near and further interest rate expectations and their effects (amongst others) on the stock markets. Thanks!

  2. DominickBakerm88 Says:

    Can i have more info on this ?

    Thanks
    mike alamper
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  4. Furniture in North Carolina Says:

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