What is the yield curve telling us on financial markets

In the post What is the yield curve telling us about economic recovery we have analysed the development of the yield curve and its messages as regards the economic outlook. In the following post, we are going to explore the messages of the yield curve development on financial markets. This is an excerpt from our latest Top Down Outlook:

Considering that the slope of the yield curve is a reliable indicator of economic direction, it is interesting to assess the predictive power of the yield curve relating to major financial markets. As a first step, we should look at the S&P500 returns as a function of different assumptions about the yield curve steepness. Since 1953 a strategy consisting in buying the S&P500 when the yield curve is positive and exiting the equity market and investing in T-Bill when the yield curve is inverted has produced a 7.7% average annual compound return against +7.3% of a buy and hold strategy - without considering the returns delivered by T-Bill when no position has taken on equity markets. The average monthly return stands at 0.74% when the yield spread is positive and at -0.2% when it is negative.

However, equity markets recorded their highest returns when the spread between the long term rates and the short term rates was above 1% but below 2%. In this case the average monthly return was 1.3%. When the yield spread is above 3% as it is now (this has occurred in 64 months since 1953, 10% of the total), the S&P500 sees a 0.5% monthly return. For this reasons, should the yield spread remain above 3%, we would expect a positive performance for the S&P500, though lower than the historical average monthly return (+0.65% since 1953).

The slope of the yield curve also has a reliable predictive power for the returns delivered by all other international equity markets. For example, since 1993 the German Dax Index has brought a 1.2% average monthly return when the spread between the long term rates and the short term rates was above 1% and a 0.2% return when the spread was below 1%.

Finally, we should consider the predictive power of the yield slope with respect to the government bond market. A very steep yield curve has been usually followed by a decline in long term rates and an increase in short term rates. This relation is not a major surprise. Indeed, we have showed that a very steep yield curve has been traditionally followed by robust economic growth. This has prompted many Central Banks into monetary tightening, hence pushing up short term rates, which are closely correlated with the overnight rates set by the Central Bank, but into lowering long term rates as investors start discounting more moderate economic growth and growing inflationary pressures. A similar pattern has also appeared in the German Government bond market. Overall, we are looking for a flattening of the yield curve both in the US and in the Euro zone in the months ahead.