Why You Must Watch The Bond Market & Yield Curve
We now know that the economy cannot reliably predict how a market moves, but what if we see things from the opposite perspective – can the markets predict the economy?
Well, for the stock market, the answer is also a resounding no.
After all, it is (in)famous for being able to not reliably predict recessions. Paul Samuelson put it well when he said:
“The stock market has predicted 9 out of the last 5 recessions.”
Of course, the specific numbers will change depending on where you come across it, but the first number will always be larger than the second.
These days, the quote is often used in a way that is meant to be funny.But with how much so many commentators and traders bend over backwards to explain in their narratives any divergences in economic and stock market performance, it does make one wonder if the aphorism is more sad than funny.
Now, the bond market on the other hand, is a much better predictor of economic recessions.
Specifically, the spread between 2 and 10 year US Treasury (UST) yields have been predicting recessions accurately since the 1970s.
Every time the 2-10 spread has fallen below 0 (known as an inverted curve), that is the yield on the 2 year is higher than the 10 year, the economy has fallen into recession soon after.
This particular spread is used (as opposed to the spread between, say 3 month and 5 year USTs) as the 2 year is seen as the longest maturity UST over which the Fed’s interest rate policy holds sway. Meanwhile, the 10 year UST is the benchmark interest rate for a large portion of the global fixed income market.
Also, intuitively, the 30 year bond’s yield is too long term a rate to use.
Hence, when short term rates, as represented by the 2 year note, rise higher than those of the 10 year, it is an indication that money is harder to borrow in the short term than it is in the longer term.
This is of course not something that happens except in very strained borrowing and lending conditions; i.e. recessionary conditions.
If any market can make a claim of fulfilling the mainstream’s notion of Markets = The Economy, it is the bond market, specifically US Treasuries.
Given the global importance of the US economy and how interconnected the world’s economies and financial markets are, an inverted US yield curve is not a good harbinger of things to come globally.
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