the predictive power of the yield curve

The vast majority of posts on this blog will be centered around my investment philosophy which is 99.9% bottom up, value based, fundamental analysis. However, there are a few macro indicators that I keep track of in order to take the “temperature” of the overall market. While I would never base an individual investment thesis or overall portfolio structure on macro analysis, I think it’s important to keep track of where the market is in it’s cycle.

“Investment markets follow a pendulum-like swing: between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between overpriced and under-priced”

– Howard Marks


Of all the indicators oft-quoted by market pundits, the only one that I’ve found to be a reliable forward indicator is the yield curve – specifically the difference between the yield on the US 10 year and the US 3 month T bill yield.


The yield curve is a graphical representation of the interest rates for equal quality bonds with differing maturity dates. The shape of the curve provides an insight into market expectations regarding future interest rates and economic activity. In normal, prosperous times, the curve gently slopes upwards indicating the market expects economic growth to continue and yields in the future to be higher than current levels. This occurs because investors demand shorter term bonds because they expect interest rates to rise in the future (and therefore, want to be able to re-invest at the higher rates) driving down short term yields and creating an upward slope.


Yield curves


The opposite occurs when the market expects economic growth to slow in the future. In this scenario, investors buy long dated bonds with higher yields, in an attempt to “lock in” the higher rates. This causes the yield curve to invert and is very often an early indicator of storm clouds on the horizon.


To track changes in the shape of the curve over time, we can take the yield on a very short term treasury, such as the 3 month rate and deduct it from the 10 year. The larger the positive difference, the more upward sloping the curve is, while a negative value would indicate an inverted curve.

Yield curve history

Over the last 40 years, the spread between the US 10 year and the US 3 month, has oscillated between +4% and -1% with an average rate around 2%. More importantly, every time the spread has gone below 0% (i.e. the yield curve inverted) a recession has occurred within the following 12 months.


Since the 1950’s there have been 7 recessions in the United States. The yield curve spread was below 0.75% (the worry line) 12 months prior to all but two of them. Importantly, this indicator does not seem to diminish with age, as it began flashing worry signals in early 2006 before fully inverting in August that year (15 months before the official commencement of the Global Financial Crisis).


The indicator flashed warning signs for 5 of the last 7 recessions, 12 months in advance, and saved an investor from an average 14% decline in the 24 months post the initial warning sign.


Another positive aspect about this indicator is that is doesn’t give too many false signals, allowing one to avoid becoming a permabear who is always out of the market and “eventually proved right,” only to never make any money. Since 1982, the indicator has crossed the “worry line” 5 times, with only 1 being a false lead indicator of future S&P 500 returns:

S&P vs spread.PNG


As global economic growth has accelerated this year and the FOMC has indicated their intentions to pursue further rate rises, the short term yield has rocketed higher, while longer duration rates remain lower than where they were at the start of the year. This has caused a dramatic compression in the yield spread and was the impetus to write this post.


While the spread still remains a while away from the “worry level” (~75bps) I find it odd that no mainstream media sources have made any comments around the compression seen so far this year. It’s something I keep a close eye on and should it cross into the “worry zone” I’ll make sure to keep my readers informed…


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