Is Yield Curve Analysis Even Useful Anymore?
By Alex Bernal Dec 24, 2012 11:00 am
A trader looks back at past yield curve signals and the popular delusion of the US long bond.
August 2007: Volatility Expansion in the Short end of the Yield Curve -- Smart money opens the flood gate spill of liquidity that is dumping into the short end of the curve. This is a key chart to visualize because when we get to where we are in the curve today the "wiggle" room as I like to call it is nonexistent in the short end. Consequently, and rather suddenly, just before the stock market makes a major peak, the yield-hungry investors start running for cover in the so called "flight to quality," loading onto the short end and depressing the yield like it's the last Black Friday on earth. This heightened rate of change in the yield curve slope is one of the key measurements to note. The stock market here retreated from its all-time high seemingly unbeknownst to the fear that was being shown in the yield curve.
October 2007: And We Have Liftoff; The Steepening Begins -- The stock market makes a clear double top formation and shortly after confirms a lower low reversal in the dominant trend. However, the yield curve steepening accelerates, and according to some pundits at the time, a "normalizing yield curve" was telling the story that the Goldilocks economy was all right and the good times would roll forever (complacency is a classic sentiment indicator of the terminal phase of bull markets). Please see "Peter Schiff Was Right" on YouTube if you enjoy a good truth smack.
Meanwhile, I remember this period of time very vividly because it occurred during my first weeks of trading yield curve spreads. I still have the look of all my cohorts' faces burned forever into my mind… mostly coming by way of the curve movement in the next chart. I'm sorry to say that this period was a career-ending one for many spread traders who did not see the tectonic shift in the entire space coming.
February 2008: "There She Blows" Flight to Quality Depresses the Short End of the Yield Curve -- This is where I clearly realized it was not necessarily the direction of treasuries that matters or even the upward or downward movement of the curve as a whole, but the rate of change of the curve slope and the difference between bond spreads of different qualities. The chart clearly indicates how the insatiable buying in the short end pushed down the short end yields. And suddenly the bond market realized that the Titanic was sinking and all the life rafts were gone. But, at the same time, the majority of stock traders were considering this a "buy the dip" opportunity. The secular bull market in stocks had a few more weeks to be confirmed by classic Dow Theory sell signals, but the "official" bear market wasn't publicly declared and broadcasted until the second part of 2008 when the S&P breached the 1280 lows and went into the panic phase of the bear market.
Long RRPIX and short TLT Call Spreads (related securities).