Thoughts on Business Cycles, Recessions, and Financial Markets (Part 3)

Exiting Equities: The Yield Curve

One of the metrics getting much discussion of late, with a great deal of merit, is about the spread in the yield curve: the difference between long and short term interest rates. The Fed tightens monetary policy by setting the very short term ‘prime’ rate, which is what you see in a money market account. Longer term rates are set by the sentiment of the investor community at large based on their views on inflation, economic performance, etc. Usually, investors require additional interest to get them to commit for longer durations, and therefore the shape of the yield curve is upward sloping. In some instances though, short term rates are higher than long term rates. This is called an inverted yield curve.

Philosophically it means that the market is not worried about longterm inflation but is instead concerned with longterm return of principal. Historically, the yield curve has been a very solid indicator of future economic trouble, although as a timing mechanism, it is rather poor.

Today, I spent some time looking at how the yield curve spread works as a predictor of future equity market returns. For purposes of clarity, I am defining the ‘Yield Curve Spread’ as the difference between the 10 year and the 2 year Treasury rate, and equity market returns to be the total nominal market returns, inclusive of dividends, for the S&P 500.

If I break the yield curve spread down and its subsequent returns into deciles, something very noteworthy emerges in the 1st and 2nd deciles: low levels of the yield spread are associated with extremely poor 3 year equity returns.

If I combine this information with the belief that the ultimate triggering event for a recession is itself random, in my view, the prudent conclusion is that the time to reduce (or perhaps eliminate entirely) equity exposure is when the yield curve spread is very weak. Certainly negative, but perhaps setting a threshold of 0.2 depending on tolerance for risk. For clarity, at the time this work was authored, we were at a range of about .66, solidly in the fourth quartile and not consistent with an impending recession. That has sense narrowed to a band of 0.25 (as of August 2018), alarmingly in the area where 3 year returns have historically been rather terrible.

Continue to Part 4