The Yield Curve That Flattens Your Pessimism

| About: SPDR S&P (SPY)
This article is now exclusive for PRO subscribers.


What is the history of the US Yield Curve?

Is the current yield spread actually scaring investors?

A US Yield Curve vs a Global Yield Curve.

In our last article here, we showed how the weighted average SPY P/E ratio of 19 is nothing exceptional given the last 30 year changes in the S&P 500 drivers for the P/E ratio.

The bond market changed in the last 30 years as well, probably to a greater extent than the stock market did. Before we address such matter, let's check what a yield curve actually is and what we can learn from it.

A yield curve typically plot the difference between long-term and short-term bond rates for a given country. As a proxy for long-term bond rates, investors use the 10-year Treasury rate and for the short-term rate, they use the Federal Funds Rate. These two are the rates that matter for banks profitability. Given the spread among the two rates, we may fell on one of these scenarios:

  1. Negative spread: something is wrong in the credit market and banks do not have any incentive to lend given that it costs more to borrow short-term that what you can get from funding long-term loans.
  2. Very high positive spread: anywhere above a 2% spread. Banks have incentives to lend more and take risks.
  3. "Somewhere-in-the-middle" positive spread: anywhere between 0% and 2% spread. Banks have more incentives to properly assess the risk before lending given that they are paid less.

As you can see from the picture below, US experienced all three scenarios several times in the past and, as of 16-06-2016, we are currently in the scenario 3, with a moderate and positive spread but in a downward trend since January 2014. The current value is 1.19% in spread. The shaded areas in the graph indicate US recessions and we added on top a dash-dot line at the current level to easily show you how US has been for several times, and occasionally for several consecutive years, under the current value without experiencing any recession.

The lesson here is clear: low or negative spreads in the yield curve are not reliable signals to get out of the market on themselves. Additionally, US banks are not the same banks of 20 or 30 years ago. In the last decades, the world economy became more tightly integrated, new technology and the access to new markets have propelled cross-borders capital flows. Many major US banks are able to borrow from one country and lend in another while hedging the currency risk with very low transaction costs.

The globalization of banks reduces the importance of any single country yield curve for US banks and US corporations. A global yield curve is what really matters. Obviously, the greater is the GDP contribution to the world GDP of a given country, and the greater will be the relative importance of that specific country for the global yield curve.

In order to identify the current spread for a global yield curve, we will build a GDP-weighted average of the most important world countries. We select all countries where bond trading is practical and whose GDP fall within the 90-percentile of all GDP listed in descending order. This criteria excludes countries that are too small to attract significant capital flows.

The estimated GDP figures for 2016 are extracted from the IMF database here in US dollars. The bond rates are extracted from each countries' governative websites and/or financial websites (for instance here and here).

The countries of our benchmark for a global yield curve are 38 in total and the top 10 by estimated GDP for 2016 with their relative spread and weighted spread are listed below.

The yield spread is calculated using the 10-Year Treasury bond rate for the long-term rate and the 3-months rate for the short-term rate.

The total GDP-Weighted Yield Spread for all 38 countries of our sample is 0.89. If you plot the historical values for the US and a global yield curves you can see that globally the curve has spent less time in a negative territory when compared to the US yield and that the positive values are well correlated.

Sources: Federal Reserves Bank of St. Louis and Ken Fisher book "The Only Three Questions That Still Counts".

Nonetheless, you may notice that if were to step out of the stock market in 1996, when the US yield curve was close to a 0% spread, you would have missed several years of high returns. The world yield curve would have told a different story even if back then in 1996 the actual level of globalization for US banks was very far from today levels.

When comparing the US recessions with the global yield curve, you can see that, during the last 30 years, the world yield curve has been a better predictor of US recessions than the US yield curve alone.

Nonetheless, the yield curve is just one indicator no matter if it is country-specific or worldwide and you cannot accurately time a bear market on this indicator alone. We do not believe anyone should plan his/her investments on it. And more generally, we do not believe anyone should try to time the market.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.