Yield Curve Near Ten Year Highs

The yield curve is an often quoted measure of the relationship between short and long term interest rates on US Treasuries.  While there are many variations, the most often quoted measure is the difference in the yields between the 10-Year and 3-Month US Treasuries.  While the curve is normally positive (ten-year yields more than three month), there are times when the three month yields more than the ten-year, causing the curve to invert.  When this occurs, monetary conditions are considered to be tight and the market is anticipating a slowdown in economic activity.  In most periods when the curve becomes inverted, a recession is typically not far behind. 

As shown in the chart below, over the last ten years the yield curve and the S&P 500 have had an inverse relationship (we recently published a more detailed analysis for Bespoke Premium subscribers where we summarized the S&P 500's performance based on different readings in the yield curve).  In late 2000, when the market and the economy were near their peaks, the yield curve was near its lows.  As the economy weakened, the S&P 500 declined and the yield curve started sloping upwards.

While an inverted yield curve has been a reliable precursor of impending economic weakness, steeply sloped yield curves have historically been a sign that the market is anticipating strength in the economy (as was the case in 2002 and 2003).  If this is the case, just as the market is now awaiting the NBER's official recession call, one year from now, we may be waiting for the NBER to say the recession has ended.  The current difference between the yields on the 10-Year and 3-Month Treasuries is 360 basis points, which is near the highest levels of the credit crisis as well as the highest levels of the last ten years. 

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Comments

[Michael S]

Bespoke - attached a link to a test of a strategy by Boucher that plays the relationship between 10-year and 3-mo Treasuries (strategy #2 in the study):

http://marketsci.wordpress.com/2008/11/14/test-of-boucher-strategies-using-treasury-yields-to-trade-the-sp-500/

michael

[Mark]

Didn't Bespoke point out not too long ago on its website that,

"After ten straight months of job losses, the NBER's head of the recession dating committee stated the obvious - the US economy is in a recession."

So what is it?

[J Edward]

The best way to describe money in the current financial system is the willingness and ability of banks and other financial intermediaries to lend and leverage. The amount of money in the system ebbs and flows with that notion.
The willingness and ability to lend for the most part is a basic result of the return on money being greater than the cost of money to the lender. While the yield curve provides much of the information needed to determine the spread between the cost of money and the return on money, it is lacking. The component missing is inflation. Inflation is a cost of money for a financial lending institution as well. Inflationary expectations alter the landscape for lenders. The cost of money may be low today but may rise next year making the spread or profit on a marginal loan undesirable.
The best example of the predictive powers of this additional input is 1987. In looking at FIGURE 1 using a traditional yield curve, the cost of money never rises above the return of money in the fall of 1987. Looking at FIGURE 2 the adjusted cost of money rises above the return of money creating a liquidity crisis, resulting in a market crash.
The adjusted cost of money used in FIGURE 2 is 3 month TBill rates plus Currency Inflation.
Currency inflation is different than Consumer Price or Wholesale Price input which a). are lagging information and b). are not pure in that it can reflect shortages of goods. Currency inflation is determined by the present price of gold ( which we spoke about earlier as a store of value ). Gold provides an anchor to measure the dollars weakness or strength. Gold moves counter to the dollar. When confidence in the dollar wanes the dollar goes down, but we see at as rising gold prices. It is not the price of gold that is going up it is the fact that we are paying more dollars for this same store of value. While gold my not be the perfect proxy for the dollar
( actually an inverse proxy since they move opposite of each other ), it is believed by many to be the most accurate. So the Currency Inflation number is derived by taking the price of gold, inverting it and using a tabled formula creating a pure inflation number that is important in determining the cost of money.

Another important feature of the Liquidity Model is that it not only determines increase in liquidity ( meaning economic expansion ahead ) or lack of liquidity ( meaning economic slowdown coming ), it contains the type of contraction that is ahead.
Over the last 20 plus years we have had 3 deflationary financial contraction and 3 inflationary financial contractions. The deflationary contractions are also called recessions.

Note 1 . The charts could not be copied over, sorry.
Note 2 . In 2008 Gold and the US$ moved in the same direction. Kind of. Actually the US$ moved up against Other currencies. Gold prices moving up reflected that the US$ was simply the one eyed kind in the land of the blind. i.e. relatively the US$ was weak creating a cost of money number that created a virtually inverted yield curve. This explains why the yield curve is wide open yet there has been no GDP growth improvement and there will be no improvement until this is rectified.