Today’s Trading Lesson From TradingMarkets

The bond market has
a crystal ball that the equity market should take a look at: the yield curve.
The events of this past year have once again proven the value of using the yield
curve as a predictor of future economic and financial events. 

For investors that
heeded the warnings inherent in the yield curve at the start of last year, they
are now sitting on a pot of gold.  For everyone else, well, they are looking at
their stocks like a deer at headlights. 

Before I go on, let
me give you a little primer on the yield curve. For simplicity’s sake, assume
that when I say “yield curve” that I am talking about the yield curve for U.S.
Treasuries.

The yield curve is
basically a chart that plots the yields on bonds carrying different maturities
usually ranging from 3 months to 30 years.

When bond investors
analyze the yield curve to try to glean its meaning, they look at the difference
between yields on short-term securities compared to that of long-term
securities.  The spread between the 2-year note and 30-year bonds is commonly
used.  A “normal” yield curve is one in which long-term maturities have higher
yields than short-term maturities.  In such a case, the yield curve is deemed to
have a positive slope.  The curve is considered inverted when long-term
maturities have a lower yield than short-term ones.

The shape of the
yield curve can mean a variety of things to bond investors but there are two
basic ways of looking at it.

First, if it is
“positively sloped” this is usually an indication that the Federal Reserve’s
monetary policy stance is and will likely continue to be friendly toward the
markets.  That is why the yield on short-term maturities is lower longer
maturities (the Fed controls short-term interest rates).  A friendly Fed is
usually good news to stocks and to the economy.  So a steepening yield curve
generally forebodes good times for investors over a several quarter horizon.

On the other hand, a
“negatively sloped” yield curve usually indicates that Fed policy is unfriendly,
with the Fed engaged in a strategy to slow the economy by raising short-term
interest rates.  This, of course, generally portends a gloomier set of
conditions for the equity market as well as the economy.  In fact, since 1970
every inverted yield curve has been followed by a period in which S&P 500
earnings growth was negative.

The yield curve is
thought to be a better predictor of the economy than the stock market and can
therefore give you an edge if you follow it.  Indeed, studies have shown that
the yield curve predicts economic events roughly 12 months or more in advance
while the stock market is thought to foretell events 6 to 9 months in advance.

The events of 2000
were forewarned by the inversion of the yield curve at the start of the year in
January when it inverted for the first time in about ten years.  While many
investors and analysts dismissed the inversion as related to technical factors
such as Uncle Sam’s buy-back of the national debt (which entails the purchase of
long-dated maturities, mostly), there were clearly other reasons for the
inversion that had implications for the markets and the economy.

First of all, the
inversion was occurring because the bond market was beginning to believe that
the Fed would have to raise rates aggressively to slow the economy.  That’s
exactly what happened; the Fed raised rates one full percentage point over the
next four months.  In turn, bond investors began to believe that economic growth
would decelerate. 

It did.

Stock investors took
time to heed the yield curve’s message that the Fed would put its chokehold on
the economy but it didn’t take all that long.  It is probably no coincidence
that the Dow Jones Industrial Average peaked the same month the yield curve
inverted.  The S&P 500 and the Nasdaq peaked just a couple of months later in
March.

So what is this
crystal ball telling us now?

For starters, note
that the yield curve became positively sloped for the first time in almost a
year on December 9, 2000.
  The return to a positive slope has a few implications for the markets and the
economy.  First and foremost it indicates that the markets expect the Fed to be
friendlier toward the markets.  Indeed, the Fed has already turned friendly
toward the markets having announced a surprise rate cut on January 3.  Moreover,
the bond market is priced for nearly 150 basis points of additional rate cuts
this year.

Second, as a result
of the expectation for future Fed rate cuts, the bond market believes the
economy will regain its footing again after a period of weakening.   This view
is reinforced by the notion that the Bush administration will be successful in
pushing through a tax cut this year. 

Both the rate cut
and tax cut hope also augurs well for the stock market because they typically
boost economic growth, thereby boosting corporate earnings.  Lower interest
rates, of course, also reduce the competition for capital, as investors flee
lower yielding interest rate products and move stocks where returns are usually
much higher.

The increased hope
for a friendlier Fed is already helping cyclical companies including basic
materials companies such as Dupont, International Paper, and Caterpillar. 
Retailers and technology companies have also started to gain despite continued
weak fundamentals.  All of these companies have one thing in common: hope that
the Fed will cut rates and thereby invigorate the expansion and boost corporate
profits.

If these hopes are
fulfilled, we will be able to look back and say that the yield curve called it. 
Again.  The yield curve warned in 2000, “Don’t Fight the Fed.”  In 2001, that
message is being sent again, but with an entirely new meaning.

There are other
means by which the bond market can help you to spot key turning points in the
stock market and the economy.  I will discuss this in my next lesson.