Study: a better yield curve for predicting the stock market is bullish


The Treasury yield curve is flattening, which has some investors and traders turning bearish. Most people focus on the 10 year – 2 year yield curve, which is close to inverting.
*Investors and traders only need to be careful once the yield curve inverts. A flattening yield curve on its own means nothing until it becomes inverted.

As you can see, the 10 year – 2 year yield curve is close to being inverted. It currently stands at 0.24%
HOWEVER, the 10 year – 2 year yield curve isn’t the best yield curve. The 10 year – 2 year yield curve tends to become inverted too early, which means that it becomes bearish too early.
The 10 year – 3 month yield curve is a better yield curve because it tends to invert later. When it inverts, it gives you a more timely SELL signal. The 2 year Treasury yield tends to be higher than the 3 month Treasury yield.
The 10 year – 3 month yield curve is still far from being inverted. It recently fell to 0.83%

When the 10 year – 3 month yield curve falls to 0.83% for the first time in an economic expansion cycle, the stock market usually continues to go up.

Here’s another way to visualize the S&P 500’s 2 year forward returns when the yield curve flattens to 0.83%.

Click here to download the data in Excel.
June 27, 2005
The stock market rallied for 2 more years before topping in 2007, even though there were multiple “small corrections” along the way.

May 24, 1995
The stock market went up over the next 5 years before topping in 2000. There was a “big correction” and multiple “small corrections” along the way.

January 17, 1989
The stock market rallied for another 1.5 years before starting a “big correction”, which the Medium-Long Term Model predicted.

September 30, 1980
The stock market rallied for another 2 months. Then it swung sideways for the next half year before starting a “big correction”.

September 1, 1978
The stock market rallied for the next 2 years, even though there were multiple “small corrections” and a “big correction” along the way.

January 24, 1973
The stock market started a bear market when the 10 year – 3 month yield curve flattened to 0.9%

July 9, 1963
The stock market rallied for 5.5 more years before a bear market. There was a “big correction” and multiple “small corrections” along the way.

Conclusion

The 10 year – 3 month yield curve is a better yield curve. Based on where it is today, the stock market will probably continue to rally in the medium-long term.
There is only 1 terriblybearish case out of these 7 historical cases. That was due to OPEC’s oil embargo. Unless Trump’s trade war results in a global catastrophe and recession, that bearish case is unlikely to play out today.
Trump’s trade war with China is expected to shave less than -0.2% off of U.S. GDP growth. With the U.S. economy growing at 3-4% a year, this trade war will not have a big impact on the economy.
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1 comment add yours

  1. Great post! As working on a bond trading desk, this article has some great information.

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