Yield Curve Indicator Shows No Sign Of Bear Market

Yield Curve Indicator Shows No Sign Of Bear Market
Bear market won't come until the yield curve says so: Kleintop

by Ben Eisen

Jittery investors who are looking to the indexes for signs of an approaching bear market might do better by focusing their attention elsewhere: on the yield curve.  So says Jeffrey Kleintop, chief market strategist at LPL Financial, who asserts in a note this week that the yield curve has a perfect track record of predicting the top of the stock market over the past 50 years, and it's not signaling a bear market right now.

The yield curve is another way of describing the difference between short-term Treasury yields and long-term yields.  It's a favorite tool among financial and economics wonks because of what it says about the economy.  The widening between the yields of different maturities, known as a steepening curve, often signals a brightening economic outlook.  On the contrary, if the curve flattens considerably, the growth outlook tends to be souring.

If the Federal Reserve aggressively hikes its key policy rate, short-term Treasury yields in turn rise swiftly.  If short-term yields climb higher than long-term rates, the curve is said to invert.  An inverted yield curve is generally a sign that a recession is about to begin, which means that it's also a predictor of the top of a bull market in equities, says Kleintop.

There are a number of different Treasury maturities one can use to calculate the yield curve, but Kleintop chooses to find the spread between the 3-month T-bill  and the 10-year note (TLT). 

Here's where that differential has turned negative over the past 50 years, and how it compares with the S&P 500 index (SPX) (SPY):

Historical Yield Curve Chart

Writes Kleintop:  "Every recession over the past 50 years was preceded by the Fed hiking rates enough to invert the yield curve.  That is seven out of seven times - a perfect forecasting track record.  The yield curve inversion usually takes place about 12 months before the start of the recession, but the lead time ranges from about five to 16 months.  The peak in the stock market comes around the time of the yield curve inversion, ahead of the recession and accompanying downturn in corporate profits.

This puts Kleintop in the same camp as Jonathan Golub, chief U.S. market strategist at RBC Capital Markets, who also claims the the bull market has more room to run because a recession isn't imminent.

So now you're worried about when the curve will invert.  The yield curve has certainly been flattening over the last half year as bond investors fret about when the Fed will begin hiking its lending rate, which has been pegged near zero for the past half decade.  But the good news is that the curve is still steep - and certainly a long ways from inverting. Here's what the curve looked like this week:

Current Yield Curve Chart

 

As Kleintop writes:  "Even if long-term rates stay at the very low yield of 2.6%, to invert the yield curve by 0.5% the Fed would need to hike rates from around zero to over 3%!   Based on the latest survey of current Fed members that vote on rate hikes, conducted earlier this year, members do not expect to raise rates above 3% until sometime in 2017, at the earliest.  The facts suggest the best indicator for the start of a bear market may still be a long way from signaling a cause for concern."

Courtesy of MarketWatch