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Is Yield Curve Analysis Even Useful Anymore?


A trader looks back at past yield curve signals and the popular delusion of the US long bond.

A lot of people have their pet theories on what a steepening or flattening yield curve means for the stock market. From CNBC to Bloomberg, there are no shortages of academic explanations. That said, I have been analyzing and trading the Treasury and Eurodollar curve for many years now and have formed my own theories. One thing that is clear in my mind is that interest rates have a huge effect on stock prices. But sometimes those relationships are very complex to see.

Let's first take a short trip back through time to get a better look at where we are today.

May 2005: Signs of Flattening in the Midsection of the Curve -- The first forewarning of a possible slowdown in the business cycle is when the short end finally becomes saturated and the market chases yield. The bull market in equities enters a grinding rangebound phase as the liquidity was still saturating into the housing market sector to fuel the upward move rather than reinvesting into the capital structure of the economy.

June 2006: Flat Yield Curve -- This is the classic dead canary in the coalmine preceding an economic slump; the short end of the curve is sold by bond vigilantes as they demand higher yield. The flat yield curve signaled that the bond market was weighing the severity of the risks of the toxic debt… an explosion that was about to take hold.

March 2007: Inverted Yield Curve -- This is the definitive sign of the end of the secular bull market in equities and high-yield instruments. The inverted yield curve points out that fears of inflation were putting a lot of pressure on the short end of the treasury curve. Unbeknownst to the stock market, the effects of a credit "squeeze" were about to take hold. I have seen statistics over the past several years that indicate an inverted yield curve has a 80% to 90% probability of predicting a recession within the next six months. This is often seen as a "last call for alcohol" for getting out of stocks and parking funds into the short end of the yield curve, which starts to pay much higher interest rates than the long end. This is exactly the paradox that tells us that something irrational is going on in the market. Let the hysteria ensue…
Long RRPIX and short TLT Call Spreads (related securities).
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