Why the yield curve matters

I’ve been thinking a lot about Ray Dalio’s words recently:

The main thrust of machine learning in recent years has gone in the direction of data mining, in which powerful computers ingest massive amounts of data and look for patterns. While this approach is popular, it’s risky in cases when the future might be different from the past.
Investment systems built on machine learning that is not accompanied by deep understanding are dangerous because when some decision rule is widely believed, it becomes widely used, which affects price. In other words, the value of a widely known insight disappears over time.
Without deep understanding, you won’t know if what happened in the past is genuinely of value and, even if it was, you will not be able to know whether or not its value has disappeared.

I am focusing particularly on that last point – “deep understanding”. I want to know why things are the way they are, instead of just doing surface level analysis with macro data.
It’s inherently logical why the stock market and economy move in the same direction in the medium-long term. The economy drives corporate earnings, which drives the stock market.

But what about the yield curve?

Why is the yield curve such a powerful predictor of bear markets and recessions? Is this just “surface level analysis”, or is there a solid underlying reason behind this relationship?
And also, why is it that sometimes, a bear market & recession starts immediately after a yield curve inversion while other times, a bear market & recession starts years after an inversion? Why does the “lead time” vary so widely?

Moreover, Stan Druckenmiller said that the financial sector’s weakness preceding the September 2018 top was a warning sign that the stock market would face trouble. He said “when the cyclical sectors like finance underperform and the counter-cyclical sectors like utilities outperform, that isn’t necessarily a long term bearish sign, but it is a long term warning sign”.

I think I’m putting 2 and 2 together…

What the yield curve really means

Ray Dalio has said that credit growth (lending) drives the economy. When credit growth slows, the economy slows, which is bad for stocks.
I have yet to see an indicator that best describes credit growth in the economy because “credit” is a very broad term. However, it does seem that the yield curve can predict slowdowns in credit growth.
The yield curve is a symbol of how profitable banks are.

  1. Banks borrow at short term rates and lend at long term rates.
  2. When the yield curve is steep, bank lending is profitable. (Borrow at cheap short term rates, lend at expensive long term rates).
  3. When the yield curve is flat, bank lending is unprofitable. (Borrow and lend at the same rates, combined with the duration risk of lending money).

The St. Louis Fed wrote an excellent article on this phenomenon in 2017.

Recently, the Federal Reserve asked banks how their lending policies might change in response to a hypothetical moderate inversion of the yield curve. Many of those surveyed indicated that they would tighten lending standards or price terms on every major loan category.
When asked why they would do so, several potential reasons were given:

  • An inversion could cause loans to be less profitable relative to the bank’s cost of funds.
  • An inversion would cause their banks to be less risk tolerant.
  • An inversion may signal a less favorable or more uncertain economic outlook.

Why is this important? Researchers have found that the economy tends to slow after banks tighten their lending standards, suggesting that an inversion of the yield curve could cause economic activity to slow by leading banks to reduce the supply of loans. Thus, an inverted yield curve might do more than predict a recession: It might actually cause one.

Some people argue that the yield curve is artificially flat right now because QE depressed long term rates. But based on this logic (yield curve drives banks’ lending), it doesn’t matter if the yield curve is artificially depressed or not.

Finance stocks

This begs the question:

Why does the yield curve sometimes invert right as a bear market & recession begins?
Why does the yield curve sometimes invert YEARS before a bear market and recession begins?

The second scenario is exactly what happened from 2005-2007. The yield curve inverted at the end of 2005, yet the bull market continued for another 1.5 years! What happened?
As you may recall, banks were insanely profitable before 2007 thanks to the real estate and mortgage bubble. So while the yield curve certainly has an impact on banks’ profitability, it is not the ONLY factor.

It’s not the yield curve that’s most important. It’s the banks’ profitability that matters the most.

  1. If the banks are very profitable lending money right now, then they will continue to drive credit expansion, which will continue to drive the economic expansion.
  2. If the banks aren’t very profitable lending money right now, then they will tighten financial conditions, which will hurt the economy.

The yield curve merely plays a big role in banks’ profitability.
You’ll notice how XLF topped before the stock market topped in 2007.

The same thing happened this year.

In a way, Stan Druckenmiller has a point when he says “the best predictor of the economy, aside from fundamentals, is the INSIDE of the stock market itself (sector internals)”.

  1. The best thing to do is to understand how the economy works like Ray Dalio.
  2. If you don’t understand the economy, pay attention to the stock market’s internals. In particular, pay attention to the cyclical sectors (like XLF) and counter-cyclical sectors (like XLU)

The internals are not perfect, as there are several false alarms. But it does serve as a long term warning sign.

In the future, I will be monitoring sectors more closely.

4 comments add yours

  1. The Sept 2011 market is most comparable to what we have today.
    Maybe some good times are ahead & also it did not need a test of the lows in September,2011.

  2. Also important to answer is “why yield curve flattens”? as far as i understand this is because investors buy long term UST as they expect interest rates cuts (thus 10y UST with yield of 3% will be attractive)

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