Just below is a chart of the spread or difference between 10-year U.S. Treasury yields and 3-month TBill yields. During the time shown the spread has ranged from a high around 38 (3.8%) down to a low close to or below -5 (-.5%).
When the spread is ‘high’ it means that the yield curve is steeply sloped with long-term interest rates far above short-term yields. This tends to push money away from cash or short-term investments as the markets offer a higher return for more risky long-term alternatives.
When the spread is ‘low’ the yield curve becomes flatter. Once the spread moves below the ‘0’ line short-term yields exceed those of longer-term bonds. This tends to pull money away from risk and back towards cash.
We have argued that the last two bear markets began in earnest once the yield spread moved below the ‘0’ line with asset prices bottoming two years later (in later 2002 and early 2009).
The problem is that the yield spread appears to have an upper limit around 3.8%. Once the spread reaches this extreme one of two things has to happen- either short-term yields start to rise or long-term yields have to decline. This brings us to today’s initial point.
Next is a comparison between the S&P 500 Index (SPX) and the spread between 10-year and 3-month Treasury yields from the autumn of 2009 through trading last week.
The yield spread touched 3.8% at the start of January and then pushed up to this level once again at the conclusion of this year’s first quarter. In both instances the stock market held through the quarterly earnings reporting period before slumping. The view is that once the yield spread reaches a maximum level and given the fact that there is still too much slack in the system to push short-term interest rates higher the only possible response is a decline in long-term yields. With the equity market trading tightly with yields this leads to a stock market sell off until the yield spread finds a bottom and begins to work back up towards 3.8%.
The argument is that the equity market’s trend should remain positive as long as the spread line is working higher with the next gut-wrenching correction due some time after the spread re-tests the 3.8% level.
Equity/Bond Markets
Below is a chart comparison between 5-year Treasury yields and an overlaid chat of the Fed funds target rate (in black) and 3-month TBill yields (in red) from 2002 through 2004.
Above we argued that the yield spread appeared to have a fairly well defined upper limit around 3.8%. With TBill yields still under .25% this puts an upper limit on 10-year yields around 4.0%.
The view was that once the spread reaches roughly 3.8% it will tend to work back to the down side. This can happen either through rising short-term yields or lower long-term yields. Many economists believe that the Fed will not start to raise the funds rate until 2011 or, perhaps, even 2012. Fair enough.
Our argument has been that the Fed will raise the funds rate at the next FOMC meeting following an upside break out by 3-month TBill yields through .25%. The chart below shows that this won’t happen any time soon given the fact that TBill yields are still close to .15%.
In any event… the point from the chart at top right is that the bond market tends to lead the Fed. The low point for 5-year yields in 2003 occurred very close to one year before the Fed started to raise the funds rate in mid-2004.
Further below we feature a chart of 5-year Treasury yields and the overlaid chart of the funds rate and TBill yields from the current cycle.
If the bond market leads the Fed by close to a year then the present situation becomes somewhat interesting. We know that the Fed didn’t raise the funds rate in January of this year one year after the low point for yields at the end of 2008 so the next logical time period for a rate hike would be twelve months AFTER whatever bottom yields make this year.
We may be guilty of making a simple point overly complex but our thought was that the slump in yields through the first half of 2010 may prove to be the bond market’s way of setting a pivot point. If yields were to turn higher from current levels and slowly work back to the recent highs then the charts suggest the potential for an initial hike by the Fed some time around the middle of 2011.
