2 Studies on the Flattening Yield Curve

A reader asked about prior studies on a flattening or inverting yield curve, wondering  "what have they concluded?"

Quite a few other analysts have looked into the question. Here are two worth considering:

Bill Gross, who manages the world’s largest Bond fund — and therefore better know about this stuff —  featured the chart below last month.

Gross’ conclusion? "By the time 10-year and 2-year Treasuries reach parity, as is almost
the case now, the economy is typically slowing and the Fed is at or
near the end of its tightening cycle."

Here is his relevant chart:


click for larger graphic


Courtesy of PIMco


Gross also observed that "Economists/investment managers are aware of the potency of a flattening yield curve (shown in Chart above). . . Only [former Fed Chair] Volcker, with his need to strangle inflation out of the system, persisted into negative yield curve territory for longer than a few months."


Further, I happened to come across this commentary — A Study on the Flattening Yield Curve — of post-1970 inversions.

The study’s generalized conclusions?

  1. Recessions have been preceded by yield curve inversions since 1970.
  2. lead time averages over 40 weeks.
  3. The S&P 500 does not do well when the yield curve is inverted (performance measured over the entire span of the inversion).

The chart accompanying that commentary  shows yield curve inversions relative to the S&P500.


click for larger chart


See the rest of the charts form various studies here.


UPDATE: December 29, 2005  1:30PM

I have made repeated references to never relying upon one lonesome single indicator, burt some of the newer reader smay have missed them. For those of you haven’t done so yet, please see Single vs. Multiple Variable Analysis in Market Forecasts . . .

UPDATE 2: December 29, 2005  3:03PM

Dave Altig of MacroBlog fame suggests NY Fed’s Arturo Estrella yield curve primer:  The Yield Curve as a Leading Indicator. Its another excellent (if somewhat jargon laden) source.

Takin’ It To The Blog
Bill Gross
PIMCo Investment Outlook, November 2005

A Study on the Flattening Yield Curve

Ron Griess
The Chart Store,  December 13, 2005

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What's been said:

Discussions found on the web:
  1. me commented on Dec 29

    I am always amused by the “this time its different” crowd. I thought that it was supply and demand that determines the slope of the yield curve. Everything I see shows housing headed down – less demand for home equity loans and refis, and less demand for housing at the higher rates. Business has not invested, at least not in the US, so I would guess there is not much demand there.

    Seems intuitive to me that less demand equals slowing economy.

  2. Saleem Huda commented on Dec 29

    This time is different….Fed has hiked 14 times and 10yr rates are unchanged while 30yr rates are 60bp lower than at the beginning of the tightening cycle. This is not typical of a hiking cycle. Long term borrowing costs have not changed since the fed started hiking.

  3. Barry Ritholtz commented on Dec 29

    Well, starting from 46 year lows is also different —

    Once the Fed rate came up to about 4%, we were back in the range of not different.

  4. erikpupo commented on Dec 29

    Wouldn’t the Fed have to raise rates more in order to prevent further inversion? It seems that if they stopped the curve would invert anyways but if they drove up rates high enough to attract capital the curve inversion would decelerate?

    I am asking only because the common Wall Street consensus seems to be the Fed is done which makes little sense to me.

  5. kmr commented on Dec 29

    This chart doesn’t really say much. There are only 11 events and out of them only 4 are obviously profitable trades. So, where’s the beef? From the chart it looks like a wash as far as making money.

  6. me commented on Dec 29

    “This time is different….Fed has hiked 14 time”

    What ever happened to don’t fight the fed? The more things “are different” the more they are the same.

  7. blue commented on Dec 29

    It seems to me that the fedchair has the same problem as in the late 70s. The fedfunds rate started unusually low and has steadily gone up but in that time, the threat of inflation hasn’t gone away. As with anything in The Market, this is up for obfuscation… err, debate. But, if there is an inflation threat then the fed cannot ‘just lower rates’, because that would loosen money.
    There are Those that would like to wish inflation away, and that might work this time , but that’s the game of chicken: Inflation vs. further fed funds hikes.

    if the fed blinks and cuts and there ISN’T inflation, then everything is fine. If the fed cuts and there IS inflation, then inflation is going to leap forward. (at that point cheney will point out that ‘inflation doesn’t matter’).

    but if the fed raises the fedfunds rate and there INS’T inflation, then the fed will not have to stay inverted for very long, and all will be (relatively) well. If the fed raises and there IS inflation then that is the point where we see rates go way up in the face of that inflation.

    i think the takeaway here is that INFLATION IS A PROBLEM. focusing on that question, is there an inflation problem? is the course I would take to unravel this ball of yarn. look at the commodities markets.


  8. Paul Hickey commented on Dec 29

    I think too much emphasis is placed on this yield curve. First off, when everyone focuses on one indicator, the expected results never come to fruition. Furthermore, I just don’t see conclusive evidence.

    Regarding the market, of the three prior instances where the curve became inverted since 1982, the S&P 500 over the next year was up twice by a large margin (15%+), and on the one down occurrence it only fell 2.5%.

    As far as the economy is concerned, it is true that the economy went into a recession following two of the periods where the curve inverted, but in each of those periods, it took over a year. What I also find interesting is that when the economy finally did hit a recession, the curve was actually steepening.

  9. B commented on Dec 29

    This is so indicative of economics. People with valid or supposed valid arguments on both sides of the issue. There may be some validity that money is still easy this time. Historical rate increases have ended with restrictive money and that isn’t here.

    That said, we have no inflation. Of course, that is what the indicators say and what many pundits say. That is because all they look at is the rate of change. So, how about an example. If inflation went from 3% to 9% in a year, the ROC indicators would obviously show significant inflation. But, if the following year inflation went from 9 to 9.1%, we would have the blathering idiots telling us inflation is in check. And then the next two years repeat. We end up with significantly higher prices but the “indicators” say all is well. But, purchasing power just took a massive haircut in that scenario. And a permanent one at that.

    So with housing, healthcare, commodities, energy and damn near everything else up hundreds of percent but tailing off on the ROC indicators, we are in pax Americana. Oh yea, productivity has eaten all of this inflation per the experts while corporate profits are at all time highs. Hmmm….Not the last time I went to a doctor or filled up with gas or bought some fertilizer for my yard or bought a house or or or.

    Uh huh. But, I’ve given up ever trying to have an intelligent discussion about this because our policy is to inflate. No one really cares what real inflation is and the policy holders don’t either because the demon is deflation. It’s 1929 revisited that scares them. It’s Japan for the last twenty years. So, any attempted logical argument is irrelevant. It’s what the Fed will do when faced with certain conditions. And that should never be confused with what is right or logical. Inflating isn’t so bad. Your house is worth a heck of alot more if you own a home. And, you do get higher pay increases. It’s just a continuation of a trend that the rich are getting richer and the poor are getting poorer. We all knew that. And we all knew no one really cared about that trend when we saw post Katrina and the fact that 500,000 Amreicans still don’t have a home but rebuilding isn’t exactly rocking. Outa site, outa mind. That great ability to compartmentalize. What has kept humans alive and productive for so long in the face of disaster…but with an ugly side effect.

    Btw, for those who are skeptical of the bond market, I’d point out that they are usually alot better at it than stock pontificators. ie, seldom wrong.

    It’s always different this time for the herd. Until the market craters. Then Chicken Little comes out. No predictions. Just a point. And a cynical one at that. Cynical for all of the positive types who never want to admit life isn’t always a bowl of cherries.

  10. B commented on Dec 29

    Paul, per your comments, is the S&P up from the last yield curve inversion? Or, is the NAZ? Just curious.

  11. me commented on Dec 29

    Well said b

  12. cm commented on Dec 29

    B: “And, you do get higher pay increases.”

    Well, not necessarily, and not everybody. For many getting a raise in line with reported inflation (maintaining reported real wage) must be good enough, and in line with actual nondiscretionary items inflation (“real wage growth”) is a boon. And some have to wait for minimum wages to be raised, regradless what inflation is.

  13. B commented on Dec 29

    I was being facetious cm…..If you couldn’t tell from reading my post, I must be losing my edginess.

  14. cm commented on Dec 29

    B: No it was clear that you were being facetious, but nevertheless you were making a point. One general problem with interpreting facetious remarks is to distinguish between things said in irony and things said at face value. But then others have pointed out to me that I’m going way too far in parsing, analyzing, and attributing meanings and motivations to things.

  15. TCO commented on Dec 30

    If inflation is such a danger, then why don’t the long term (or even any term) capital markets show it? I think a steep eyeild curve would be more relevant if there was a danger of devloving into inflation.

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