How Yield Curves Can Predict Bear Markets

by: Value Growth Investor

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).

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.

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.

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.