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Steep yield curve indicates good times and high inflation in 2010 - 2012

"Don't fight the Fed" is a well known axiom among stock traders.  This has been particularly true this decade as the Fed has been a prime driver of the stock market which has seen two of the biggest bear markets since the 1970's and two of the biggest bubbles since the roaring 20's.

The yield curve (defined as the spread between short term and long term treasury bond yields is now extremely steep and at the top end of its historical range). The following chart illustrates a relationship between the slope of the yield curve which I have calculated as follows:

slope = (yield 20  - 3 month T-Bill) divided by 19.75

This as high school math would indicate is the slope of a straight line.  19.5 years is the length of the yield curve (20 years - 3 months).

I plotted the monthly slope (on the left X-axis) vs.. monthly close of S&P 500 (on the right X-axis) over the period 1982 - 2009 from data obtained from the St. Louis Fed.

Yield Curve and S&P 500

The slope is plotted in blue (area chart) and the S&P 500 (log scale) is superimposed as a red line.  As you can clearly see the last 3 recessions clearly coincided with Fed credit tightening and the recoveries that followed were coincidental with Fed credit infusion.

In hindsight it is clear that the 2002 - 2007 market high was completely credit dependent,   On the other hand the recovery following the 1990 recession (which followed the S&L bust) was real.

Currently the yield curve is signaling a economic recovery and possibly high inflation.  A credit infusion cycle typically lasts 3 to 6 years.  We are now in the 3rd year of this cycle and given the gravity of the decline this time, I think it is safe to say that we have at least 1 more full year before the Fed can even think about tightening.  In addition inflation is very muted currently, so there is no huge pressure on the Fed to tighten, but that may change if the economy starts growing rapidly.

For reference I have plotted the treasury bond yields in the graph below:


Note:  As data for the 20 year bond is not continuous I substituted 30 years bond yield in certain places.  The curve between 20 and 30 year is almost flat so any error is immaterial to the thesis.