Monday, 22 March 2010

Using Yield Curve To Gauge The Economy Cycle

Using Yield Curve To Gauge The Economy Cycle
Posted by lionel319 @ Sun 21 Mar, 10,

What is a Yield Curve?
Here's the definition from thefreedictionary:-
At any particular time, the relation between bond yields and maturity lengths. The yield curve usually has a positive slope because yields on long-term bonds generally exceed yields on short-term bonds. The shape of a yield curve is influenced by a number of factors including the relative riskiness between long-term and short-term securities and by investors' expectations as to the level of future interest rates. 

To make it clearer, let's take a look at the below charts.
(All these yield charts are taken from

On the left shows a snapshot of the yield chart on 26th December 2002.
The right side of the chart is the price chart of the S&P500.
Lets focus on the yield chart first.

If you take a look carefully, you will notice that, debts (eg:- bonds, fix deposits, CD, loans, etc ...) which have longer maturity terms tends to have higher yield.
This makes sense. And that is why most of the time, a fix deposit in banks which has a monthly maturity will have a lower yield return than a longer term fix deposit.

Under normal condition (Normal Yield Curve), this is a good, and healthy situation.
When the short term maturity debts have a lower yield compared to a longer term maturity debts, banks could make money from it.
How they do it?
Well, banks can borrow money for the short term with low interest rate, and lend it out for longer term with a higher interest rate. This is call an arbitrage trade, where the banks earns thru the difference between the 2 interest rates.
The money that you keep in banks as fix deposit, and get a 2% interest every month? That is the short term debt that the banks are receiving.
The money that you take to refinance your housing loan, spending across 30-years, with a 5.99% interest rate? That's the long term debt that the bank is loaning out.
Now you get the picture :)

Now let's take a look at the yieldfor year 2007.

Do you see something abnormal here?
The shorter term debt (3-month) is having a higher yield(~5%)  compared to the longer term debt (30-year), with a yield of below 5%.
What does this mean?
This means that, banks can no longer earn money thru the mention discussed above.
This is call an Inverted Yield Curve.
When banks income are thinning, they will do all sorts of funny stuff in order to improve their deteriorating earnings.
And see what happens in 2008, when all the banks collapse.

And so, here's the summary
  • During normal yield curve (where short term interest rate is lower than the long term interest rate), this is a healthy state. The economy is at stage 1 or stage 2 (link). This is the best time for long term investors to accumulate stocks.
  • During inverted yield curve, the stock market will most probable hitting the top soon (Stage 3 or early stage 4). Long term value investors will hardly find any undervalued stocks during this time.

Let's take a look at a few of the past history's chart:-

The top indicator is a ratio of the 3-month interest rate versus the 10-year interest rate.
Notice that, in year 2000, during the month of July, The 3-month yield is now higher than the 10-year yield (3month:10year yield is above 1.00).
The market has shown signs of topping.
As a long term investors, you should start finding stocks in your portfolio which is very overvalued and sell them.
Because, you know that, when an inverted yield curve is happening, the economy is not far away from collapsing.
And when that happens, the stock market will follow suit.
That will be a very great time for the long term investors to pick on some really great wonderful companies which will be then at an undervalued price.

Here's another time when the Inverted Yield curve happened:-

This was 2 years ago, during year 2007.
Do you see that the above 3month:10year yield indicator is hitting above 1.00 during late 2006?
That's pretty much a good sign that the economy is over blown, and the market is about to make a turn.

Now, Let's take a look at the current yield curve ratio.

During year 2009 to 2010, the 3month:10year yield is almost touching ZERO !
This is a very wonderful time to collect some undervalued wonderful companies' stocks.
I hope you guys did collect some during that period.

Here are a few reference links regarding this topic:-
  • Stockchart Animated Yield Curve (link)
  • Another blog that talks about using yield curve to time the market tops and bottoms (link)
  • Yield curve on Wiki (link)
  • The 4 stages of a Market Cycle (link) and (link).
  • What the Yield Curve Does (and Doesn't) tell us (link).
  • Strengthening the Case for the Yield Curve as a Predictor of U.S. Recessions (link).

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