The treasury yield curve has been one of the best known and most accurate forward-looking indicators in U.S. finance. The story behind this indicator is more or less the following:
- The Fed will lower rates if the economy is struggling. Therefore if you are expecting the economy to struggle in the future you would buy Treasuries further out on the curve and hope to make money as Fed purchases drive the yields down. This purchasing would immediately drive down long-term yields predicting future rate changes.
- The yield on long-term investments in stocks is expected to be so low that even the lowered Treasury yields out on the curve, further in the future, look attractive. This expectation itself keeps the long-term rates from rising.
There are many other interpretations and explanations as to why this works but in the end it's very effective. The idea is that if the curve is upward sloping this forecasts strong stock market performance while if it's downward sloping it may be time to switch to other investments.
Option Yield Curve
The option yield curve is a similar idea but instead of measuring demand for treasuries in the future, and then indirectly inferring the future forecast for stocks from that, it measures the demand for stock call options directly. The story is the following:
- If market participants are expecting long-term increases in the stock market they will buy longer-term stock options, therefore increasing the yield on those options. This generates an upward sloping yield curve.
- If the market participants are expecting short-term increases that are not lasting they will buy short-term stock options to profit from the potential for a short-term rally but will stay away from longer-term options. This generates a downward sloping yield curve.
There is of course much more to this such as expected volatility and the implied yield expected on selling call options. However, in general an upward sloping curve is a positive long-term forecast for the stock market while a downward one is negative.
The Curve Turns Upward Sloping
I invest primarily in LEAPS (long-term stock options) and this means I need to roll over my options every 8-12 months in order not to have my positions expire. In recent years I got very used to having to go further out on the yield curve (further into the future) in order to pay less of an annualized premium on my positions. The following image illustrates the SPDR S&P 500 (NYSEARCA:SPY) yield curve shape in 2011. This specific image is from Sept. 5, 2011, with a strike price approximately 15% below market price.
The shape of this curve has more or less stayed the same since 2009. While the rates overall dropped by early 2012 in response to lowered volatility the shape of the curve did not change very much. This is the SPY option yield curve from Jan. 5, 2012, with a strike price also approximately 15% below market price.
However when I went to renew my option contracts in August 2012 I noticed a change. When I used the Optionize search engine to find the cheapest contracts I kept coming up with near-term expiration dates and trying to lock into something more long term had become expensive. I took a look at the SPY option yield curve and it was now definitely positive. The following image is of the SPY option yield curve on Sept. 5, 2012.
This yield curve is clearly upward sloping at least up to the middle of next year. In fact when I checked other dates throughout this past year it seems the yield curve turned upward sloping around February 2012, and has more or less stayed that way since then. This is actually a pretty good thing for me because my trading costs are low and I get cheaper near-term protection that I can roll over more often, but it made me wonder what was behind this change.
I believe that the implication here is that unlike previous rallies this stock market rally may be underpinned by long-term money rather than short-term speculators. If this is true then I think the recent stock market gains may not be reversed as quickly as many are expecting and the U.S. stock market, including the SPY, DIA, QQQ ETFs, may continue their strength well into 2013.
Disclosure: I am long SPY, QQQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.