The Inverted 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 a 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 10/09/06.

Most of the time the curve or graph will start in the lower left and rise to the upper right.  Today it sags in the middle, which means that the 2 year note is paying more than the 5 year bond.   This is an inverted yield curve.  In the past the entire yield curve has gone from the upper left to the lower right on the graph. When this happens the yield curve is said to be fully inverted.  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.  Note that the yield on the 3 month treasuries is higher than the 10 year bond.  The importance of this is discussed below.

Professor Campbell Harvey of Duke wrote about the relationship between recessions and the yield curve, proving that the yield curve outperformed other forecasting tools in his 1986 dissertation at the University of Chicago that was published in the Journal of Financial Economics in 1988.  I recommend Professor Harvey's website as a great source for financial and economic information.  http://www.duke.edu/~charvey/

In 1996, economists for the New York Federal Reserve Bank, Arturo Estrella and Frederic S. Mishkin, published an article in the "Current Issues in Economics and Finance" published by the New York Federal Reserve Bank.  They compared the value of the yield curve as a prediction tool to three other possible indicators, including the so called "leading economic indicators" from the Conference Board. The only reliable predictor four quarters out was the yield curve spread. More specifically, they found that the "the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill--is a valuable forecasting tool."  This paper is available at  http://www.newyorkfed.org/research/current_issues/ci2-7.pdf.

In that paper they used the 90 day average of the spread between the 90 day T-bill and the ten year bond, since there are several times where the yield curve inverted for a few days but did not stay that way for long. In these cases recessions did not follow.

Estrella and Mishkin developed a probability 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 0.46 basis points, there is a 15% probability of a recession four quarters later.  As of 10/9/06 we have a spread of -0.23.  We have had this level of inversion for almost 3 months now. So using the table below we have slightly over 30 percent probability of a recession in the next year.

 
So what do we do now.  Well, we need to monitor the yield curve over the next quarter.  If we see a full inversion increase then  the probability of a recession increases.

According to various studies, the stock markets fall 40-50% before and during a recession.  Keep in mind that the stock market is a leading indicator so it usually moves down before a full recession is in place.  With the recent strength in the DJIA we need to keep an eye on the inverted yeild curve while enjoying the potential of a soft landing. Should the trend reverse be ready to clos out your positions and capture your profits. 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.

We also need to be careful in our stock selection and place our stops to protect our hard earned capital. During these times it is imperative to select quality companies that are temporarily experiencing lower stock prices, using our stock watch list in our Premium Portfolios. When these opportunities present themselves I will update our website and send emails to all Premium Members. When warranted I will also enter trades for the the Starting Out Portfolio as well.