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Fed Delivers Steep Yield Curve: A Bull’s Best Friend at Trader’s Narrative





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If you are trying to time the stock market, you obviously have to take a look at and analyze the stock market. But a little followed indicator that has nothing to do with the stock market has historically provided amazing insight into future equity returns.

For those unfamiliar with it, the yield curve is the visual snapshot of the interest rate of different maturities of government bonds and notes. The condition of the yield curve is described by comparing the short term to the long term. There are usually three general states or categories: normal, inverted and flat. But there is also another: a steep yield curve.

Steep Yield Curve
This fourth state is usually rare but that is what we are seeing now. The 20 year treasury note currently yields 4.45% , the 10 year treasury note 3.8% and in contrast, the 90 day or 3 month treasury note is currently yielding 1.45%.

So the current differential between the 20 year note is 3.05% and the 10 year note 2.35%. During the mid-March 2008 market upheaval, the 20 year and 90 day treasury yield difference ballooned to 3.54%. Since the historical differential for the 20 year note is appx. 2% and the differential for the 10 year note appx. 1.35% this qualifies today’s yield curve as a steep yield curve.

Powering the Stock Market
So what? Why should you care if some esoteric fixed income construct like the yield curve is steep?

Because the yield curve has some heavy real world significance. It is a symbolic representation of how money filters through our economy and how it creates the prerequisites for economic growth.

According to the editor of the Systems & Forecasts newsletter, Marvin Appel, the S&P 500 performs best when the difference between the 10 year treasury note and the 90 T-Bill is between 1.41% and 2.57% with the following week providing an unheard of 13.3% return.

yield curve comparison 2007 top and 2008 rate cutWith the Federal Reserve’s 25 basis point rate cut yesterday, we now have a perfect ski hill. Notice the difference between it and the yield curve on July 16th 2007 - when the market topped out.

October was another high but for all intents and purposes, the market reached a peak that it didn’t surpass in July. The point is that the yield curve has predictive qualities when it comes to tops as well. Almost all important tops, as well as recessions, have been signaled beforehand.

What today’s yield curve is telegraphing is that the economy is about to kick into gear (again). A steep yield curve is usually observed at the end of a recession and/or just before major economic expansion. Sure, that may sound like crazy talk with all the bad news floating around. But that is how the market works. Everything is priced in. The bond market is, for the first time, holding the 90 day T-Bill rates steady even as the Fed lowers rates to meet it.

Looks like the puppy finally is willing to get caught. The gap between the 90 day T-Bill and the Fed rate is now down to just 54 basis points.

The huge and continuing gap between these two caused me to write that the Fed should cut rates immediately way back in June 2007.

Then, as now, I couldn’t believe what I was actually writing. But I had to remind myself that I wasn’t making this up. It wasn’t mere opinion, it was the market talking.

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9 Responses to “Fed Delivers Steep Yield Curve: A Bull’s Best Friend”  

  1. 1 Dan

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    ….OR….

    The engine is broke, but the operator foolishly thought the sputtering was the result of poor gasoline infusion, so the operator responded was stomping on the gas pedal with unprecedented furosity.

    Just like the amateur driver, after the stomp there is the realization: Not only were the stomps ineffective, they were beyond counterproductive. The sputtering was already occuring because the system had too much fuel, and the operator responded by adding more of the same.

    Your post resembles the foolish driver. “OK, all we need is some morfe gas!” [stomp on accelerator…stomp some more….and some more)….”That should do it. Just wait ’till all this fuel hits…Oh man, this baby’s going to take off like a rocket!”

    After 10 more acronym laden stomps, maybe…just maybe….there’ll be some realization….you’ll breathe all the fumes and emerge from the vehicle stinking of petrol in a cloud like Pigpen, and you’ll say, “hmmm…I guess it didn’t need more gas. I wonder where the choke is?”

  2. 2 Derrick

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    During Nov - Dec 2001, we do have a steep yield curve, however the mkt stilll continue to plunge afterwards, but is an interesting observation.

  3. 3 jagmohan Swain

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    Jobs number continues to paint the same picture.Lay offs happen in a big scale when recessions are not widely anticipated and business managers widely overshoot the business cycle peak by bumping their production and hence piling up on inventory.4 months into recession lay offs continue to be muted because of limited scope in production cut since inventories are lean and employment lacks the flab they usually have at prior business cycle peak.We are as far as production and employment situation goes are at that phase of business cycle that resembles a trough in business cycle not peak.Nice to have a steep yield curve manufactured by Fed cut supporting this backdrop and also the stimulus checks.

  4. 4 Babak

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    Dan,
    they don’t call him helicopter Ben for nothin’

    Derrick,
    I’ll have to double check but I doubt we had a steep yield curve during late 2001, it looks more like a “normal” curve. Find out the diff between the 90 day T-bill and the 20 and 10 year notes. Were they above the historical averages? Doesn’t look like it to me but I’m just eyeballing it.

  5. 5 Babak

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    Jagmohan,
    yes both fiscal and monetary policy are loose right now. Although I doubt the stimulus check will do anything remotely as significant as what Bernanke has done.

  6. 6 cw

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    I am reading this article on 24 Oct 08. The DOW is now at 8378, the NASDAQ and S&P are at 5 year lows. So much for the market pundits and yield curve analysis.

  7. 7 TRB

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    Now, perhaps the steep yield curve means something. LOL.

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