Predicting Market Moves Based on Yield Curve
February 10th, 2010 |Probably every investor’s biggest wish is to be able to predict the direction of the market. However, the market is so forward looking that profitability does not exactly like in predicting market returns but often in predicting the economy itself. Imagine, for example, being able to forecast economic recovery and recessionary periods before regular investor’s could. This could mean less loss (or even profitability) during market downturns by getting out or going short while others are still invested “long” and vice versa. In fact, with the S&P 500 returning 64.8% from March 9, 2009 until December 31, 2009 (or 19.7% for the entire year), knowing what the market forecasts for the economy certainly makes the task of investment management much less complicated.
One of the often overlooked tools when it comes to economic forecasting insofar as investing is concerned is the Yield Curve. Let’s take a look at what the yield curve signals about the market and tells us about the overall economic forecast:
Steep Curve
Normally, there is a three percentage point difference in yield between 3 month Treasury bills and 30 year Treasury Bonds. When that difference is more than three percentage points, the indicator from the market is that the economy is expected to enter an expansion phase. This is signal normally predicts an end to a recession and provides bond and stock market investors with cues that they will see strength in the near future.
Equity investors will study yield curves because they can have a better understanding about what the underlying companies will report in the next six to nine months. This allows them to enter some positions, close out others or ignore certain companies.
It should be noted that while three percent is the magic number, it is not an inflexible value. Studying the monthly trends of the yield curve provide a better understanding as to where the rates are headed or, better yet, where they have come from. This gives such an investor something of a head start over other investors who are relying purely on opinions from the folks at CNBC or the newspapers.
Inverted Curve
An inverted curve happens when short-term rates are higher than long-term rates. Of course, this does not always happen like this, but when rates on short term investments are very close to those offered on long-term investments, investors need to be extremely cautious if investing in equities.
The reason for the rates being so close is that bond investors would rather take a lower long-term rate because they expect the short term rates to fall through the floor. This happens whenever the economy is expected to take a pause, definitely bad news for equity investors.
Summary
While these two signals are clearly not exhaustive, they do allow investors to find the turning points in the economy and determine whether market strength is sound or simply superficial. It can also help when deciding whether to make changes to current long-term security holdings.
Want to know Where To Invest? Visit MutualFundSite.org for more tips.
Chris has more than 16 years of experience in the financial services industry. He is the Fund Advisor for the Mutual Fund Site and also manages a debt-related blog that aims to help people with Debt Trouble manage and repay debt at HowToRepayDebt.com.
Useful Links:
"Using Free Budgeting Software can help to reduce your unneccesary spending. By tracking where you money goes and avoiding overspending, you can prevent any severe financial problems."
