The Inverted Yield Curve Update - 3/3/06

On 2/1/06 and then on 3/3/06 we wrote about the concerns the Inverted Yield Curve held for the economy and the markets here.  Today we update our perspective on the inverted yield curve and what it means now.

First, a brief review of the yield curve.  The yield curve is a plot of the yield on bonds with the same credit quality across different maturities (the link above provides an interesting interactive model of the "living" yield curve).  The basic assumption is you get more interest on your investment in a bond by holding it longer.  The theory states there is more risk for holding a bond for 10 years than for 5 years, or for 5 years than for 90 days.  Bloomberg provides an current chart of the yield curve for U.S. Treasuries at  Bloomberg.  The chart below is from the Bloomberg site as of the end of business February 1, 2006.

The green line is for the current day and the orange line is the day before.

Now compare the above yield curve to the chart below as of end of business March 3, 2006.

A couple of things to note are:

• The 10 year rate is still above the 90 day T-bill rate.  The 10 year rate was below the 90 day T-Bill rate for a while in February.  Remember, these were the key rates in a study by Professor Campbell Harvey on the ability of the inverted yield curve to predict recessions.
• The middle of the yield curve has moved up dramatically and the 10 year bond rate has risen approximately 40 basis points so far in 2006.
• 10 year rates are experiencing a substantial rate increase in a very short period of time.

Recession?

How far the yield curve inverts gives us a percentage probability of the likelihood of a recession within 3-5 quarters. So, we pay attention to this curve. 

In a paper published by the New York Federal Reserve Bank, they prepared  a table about how likely a recession would be 4 quarters later given a particular level of the yield curve spread.  The spread in the table is the 90 day average.  Basically, if the spread is 0.22 basis points, there is a 20% probability of a recession four quarters later.  And that is roughly where we are today.

But that level of spread has happened several times in the past 40 years and we have not had a recession.  Keep in mind that the stock markets retrace 40-50% before and during a recession.  As an investor and trader, you do not want to wait until then to get out of your long positions.  In fact, by the time we are in a recession it is usually a good time to establish new long positions.

Current Rates

Let's look at rates as of today 6/30/06, the day after the Fed raised the the target rate to 5.25%.

What is important to notice is that the short term rate set by the Fed of 5.25% is higher than all the rates on the yield curve, and the longer term rates fell substantially the day after they raised rates. This seems to mean that the bond market believes that the Fed may be close to the end of current cycle of raising rates to fight inflation. So what does this mean for stocks? Well, typically, when the Fed stops raising rates the economy is either moving into a recession of already is in one. Stock prices usually lead the economy, so it is likely we will see continued weakness in the stock market. However, this does not mean that the market will fall without moving up as well.  In essence I expect the market to move within a trading range with the recent highs as the top of the range and the recent lows as the bottom.