Fed Delivers a Steep Yield Curve: A Bull's Best Friend

by: Babak

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 approximately 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.

With 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.