Another Look At The Yield Curve

Last year when the yield curve inverted there was concern that the inversion would be bad for stocks.  Recent moves in the fixed income market however, have caused the curve to move into positive territory.  So is this a good thing for stocks?  The chart below shows that in the most recent inversion, stocks bucked conventional wisdom and did well.  Furthermore, over the last ten years, the direction of the yield curve and the S&P 500 have, for the most part, moved in opposite directions (correlation = -0.56).  So at least over the last ten years, a rising yield curve has been bad for stocks. Over the rest of this week (as time permits), we will expand this analysis going further back.

Comments

[David Merkel]

Try this, then. Take the two variables that you are using for your yield curve slope, and do a multiple regression using either the level of the S&P, or the return on the S&P over the next six months as a dependent variable. That would help to isolate the separate effects of yield curve shape and yield curve height.

My hypothesis would be that the market likes falling long rates, and hates rising long rates, but doesn't care all that much about short rates.

Or, if you want, I can try that, and post it on my blog. Thanks for all your work; I read your blog regularly.

[oldprof]

Fundamental models, and my own experience, agree with David's comment, but we all like to see data!

The ringer in the analysis is that there was so much buzz about the inverted yield curve and the probability of a recession. Many observers doubted future earnings projections if a recession ensued.

Those of the perma-bear persuasion have taken this argument both ways. If the yield curve is inverted, earnings are suspect. If it becomes normal, it hurts market valuations.

I have written extensively on the false signal of the inversion, so I am in David's camp. Higher long rates are not good for stocks. Having said this, there is still a significant valuation gap.

[Paul Hickey]

Jeff, you are right regarding your comments of those with the perma-bear persuasion. Anyhting that doesn't fit there thesis, is always suspect! (I might add that you also find the same situation with the perma-bulls.)

Regarding the inverted yield curve, the falling rates environment sounds logical, but it doesn't explain the early part of this decade when the yield on the ten-year went from over 6% down to under 4%. This decline coincided with the worst bear market that many of us have ever experienced. Furthermore, since rates bottomed in the middle of '03, the market has done, to put it mildly, pretty well.

[Heirebaudt Frédéric]

I think that the correlation between the SP500 and the Yield curve is -0.056 and not -0.56.