Often times, Bond or Equity markets will signal potential issues or turning points in the economy before they become visibly apparent.
The fun part is to look for those signals which are not just coincidence but have causation. In other words, just because one experiences a short-term trend line between two variables, it does not point to a sustainable event.
One must seek to understand the link and logic of the trend & confirm from all angles
Shown below are two charts highlighting trend lines between two variables. The line is drawn over long windows of time (25+ years) and over several U.S Recessions.
The first is the ‘Yield Curve Spread’. It is defined as the difference between a 10 year Treasury and 3 month Treasury interest rates. When the difference or ‘Spread’ is positive then the ‘curve’ is “positively sloped”. When the difference is negative the curve is “negatively sloped”. Most recessions are due to a yield curve having a negative slope and we will circle back to this later in the blog.
The second chart is the ‘TED Spread’, which is the difference between the 3 month Treasury and the 3 month LIBOR rate. It measures the risk premium that investors demand when having to invest in Banks vs. Treasuries.
Looking at Figure 1, t’s observable that the Spread became negative before recessions in ’70, ’73, ’80, ’81, ’91, ’01, and ’07 (last 7 of 7 recessions). Similarly the TED Spread shoots up (for example in ’07) before the real economy has issues
Now lets examine the trend lines for causation (the WHY or the logic of it), which is the vital part of any market analysis.
The Yield curve spread indicates the willingness of banks to rent out money for longer windows of time (10 yrs.) to companies, while borrowing short-term money (3months/ overnight deposits) from depositors. They can earn the ‘Spread’ between the two interest rates. When the difference is large Banks are happy to lend, when difference is small or negative they less likely to lend. So as credit becomes available the economy expands, however when credit is tight it is likely to contract.
While the information above may seem overwhelming, it just might give an individual the ability to look around corners in the Market. Remember not every twitch of the curves will provide insight, but it increase the odds to better then 50-50 chance, which are the same a flipping a coin.
With this Capital Market technology, lets take a look at the current 2016 data in the charts above. Both the Yield curve and the TED Spreads are positive and within range of a relatively slow growing U.S economy. Credit is available and investors are willing to risk capital instead of parking it in Risk free products.
“The next recession is some time out”
*Past performance is no guarantee of future results. A risk of loss is involved with investments in capital markets. Please consider investment actions in light of your goals, objectives, cash flow needs, time horizon and other lasting factors.