How a Steep Yield Curve Affects Traders

12/30/2009 12:01 am EST

Focus: STRATEGIES

Corey Rosenbloom

Founder and President, Afraid to Trade

According to CNBC, the yield curve has reached its steepest curve ever. CNBC producer Lee Brodie writes, “The spread between yields on two-year notes and ten-year notes widened on Monday to its steepest level on record. Specifically, the spread between the yields pushed out to 280 basis points on Monday from 274 basis points late last week.”

Let’s take a quick look at the current yield curve, courtesy of StockCharts.com’s Dynamic Yield Curve Tool, and then compare this curve to the market peak in 2007 and the market bottom in 2003. You might be surprised!

Remember, the Federal Reserve can set short-term rates by altering overnight interest rates, but the economy generally sets the yield at the longer end of the curve, such as the 20- and 30-year yields, which are much less volatile than three-month or one-year rates.

Let’s start now with the current graph of the yield curve (December 2009), which compares short-term, intermediate-term, and long-term Treasury yield rates.

chart
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StockCharts’ data shows the three-month, two-year, five-year, seven-year, ten-year, 20-year, and finally, 30-year Treasury Yields.

The black line is the current yield curve, while the green shadow shows the recent movement over the last few months of the curve.

To the right, we can see the S&P 500 index and compare. The tool is actually dynamic, where you can slide your cursor over the S&P 500 and track changes to the yield curve, which is really neat!

Like in March 2009 (S&P 500 bottom), the yield curve was “normal,” meaning short-term yields were much lower than long-term yields—almost identical looking to the current curve because short-term rates remain unchanged (though longer-term rates are rising slightly).

What does this mean?  Actually, to answer this question, let’s step back in time five years to see the last period where the yield curve looked like this.

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Normal yield curves are associated with (or correlated with) stock market bottoms (in recent history). Lower interest rates spur investment in the economy, which helps the economy grow.

Higher interest rates hurt or discourage investment, which can lead to an economic slowdown (as companies are either unwilling to borrow debt at higher yields, or the higher yields cut into what otherwise would be profits for the company).

My point in this post is to show the recent position of the yield curve now, at the 2007 peak, and at the 2003 market bottom, instead of explaining how rates affect the stock market. That is for another day!

Speaking of the peak in 2007, let’s look at the other side the equation—a few months prior to the absolute October peak in the S&P 500. This is the yield curve as of March 2007, when the curve was “Inverted.”

chart
Click to Enlarge

An inverted yield curve occurs when the Federal Reserve raises short-term rates to a higher level than 30-year rates, or specifically, when short-term rates (such as three-month bills) have a higher yield than 30-year bonds.

Inverted yield curves are associated with market peaks. The Federal Reserve began cutting interest rates a few months prior to the October peak, so one cannot use the yield curve specifically as a timing mechanism.

The Yield Curve was also inverted in 2000, prior to the stock market peak, though this particular tool does not show data from that period.

Let’s take a final look at the prior stock market bottom. This chart shows the February/March 2003 position of the yield curve, and subsequently, the final low of a triple-bottom pattern prior to the five-year bull market that ended with 2007’s inverted yield curve.

And Now?

Again, normal yield curves are associated with rising stock markets, as we see currently. The Fed will begin raising rates when it feels the economy can withstand the higher short-term yields, which means that the economy would be moving forward and growing.

It would appear that the stock market is looking ahead for that possibility by rallying so sharply in 2009. Do take some time to study this topic in more detail—you’ll find some interesting insights.

By Corey Rosenbloom of AfraidToTrade.com

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