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In my previous article, I wrote about why I think 2014 should be another bull market. I want to continue this topic by discussing how Treasury yield curves can accurately predict an upcoming bear market or a recession.

I believe investors can benefit tremendously if they can somehow know in advance when the U.S. economy is heading to a recession or if the U.S. stock market is entering a bear market, so they can be more prepared and adjust their portfolios accordingly (e.g. hedging, short-selling, or shifting capital to fixed income or cash). Most investors were not prepared for the 2008 Global Financial Crisis. Hence, many investors experienced losses during that period.

While there are quite a few leading indicators (e.g. weekly Jobless Claims Report, Housing Starts and Sales Report), I will focus on one of them: the Treasury yield curve. I think it is simple enough for most investors and I think it can predict most bear markets as well as economic recessions.

Warren Buffett once stated, "Only when the tide goes out do you discover who's been swimming naked."

In a bull market, most stocks perform well - and investors are happy about holding them - even when they are substandard businesses or without sustainable profits!

In a bear market, the "tide goes out" and inferior companies often experience huge losses, which cause their stocks to plummet. This shows us "who's been swimming naked." This is why I think it is important to know when the S&P 500 will be heading to a bear market, which generally happens every five to seven years or longer based on history (see image below).

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In an article published on the Federal Reserve Bank of Cleveland's site, the authors showed that inverted yield curves-when short-term Treasury yields (e.g. 3 months) are higher than long-term Treasury yields (e.g. 10 years or longer)-have preceded each of the last seven recessions, including the 2008 financial crisis as well as the recessions of 2001, 1991, 1981 and 1980 (See below image).

While no indicators-including the yield curve-are perfect, I believe it is one of the simplest and most accurate ways to predict market downturns or bear markets. Note that the market index-such as the S&P 500 - is also a leading indicator and a bear market often happens right before or at the same time of a recession. But the inverted yield curve often precedes a bear market by several months to about a year in advance.

The inverted yield curve (3-month Treasury yield higher than 10-year Treasury yield) often precedes a bear market in about one year because:

  • It reflects the market's expectations of the U.S. economy in about a year or so. If investors have little confidence in the U.S. economy and are expecting short-term Treasury rates to fall, they would move their money from short-term Treasuries to long-term ones (e.g. 10 years or more), even when the yields are lower. This happens when investors expect that future yields will be lower due to a recession, so they are willing to lock their money in longer-term bonds at present yields. The Fed always reduces interest rates in response to slow economic growth.
  • It is also a self-fulfilling prophecy, similar to George Soros' reflexivity theory, where investors' expectations influence the markets and the U.S. economy. If the Treasury yield curve is inverted for a long period of time, it will eventually cause the U.S. economy to go into a recession.

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Yield curve on Jan. 6, 2014 Source: U.S. Department of Treasury

At the time of writing, the yield curve spread between the 10-year Treasury yield and the 3-month Treasury yield is nearly 3% (see above image) and the Fed is planning to keep short-term interest rates near zero-even after the unemployment rate falls below 6.5%-and especially if the projected inflation rate is below 2%. This means that the yield curve will likely maintain an upward slope-which indicates an economic expansion-for at least 2014.

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An inverted yield curve about one year before 2008 financial crisis; source: U.S. Department of Treasury

On the other hand, I believe it is important to look out for inverted yield curves (see above sample) which happen from time to time. I believe it is the one of the simplest and most accurate ways to predict bear markets about several months to one year in advance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: How Yield Curves Can Predict Bear Markets