The yield curve is an often quoted measure of the relationship between short and long term interest rates on US Treasuries. While there are many variations, the most often quoted measure is the difference in the yields between the 10-Year and 3-Month US Treasuries. While the curve is normally positive (ten-year yields more than three month), there are times when the three month yields more than the ten-year, causing the curve to invert. When this occurs, monetary conditions are considered to be tight and the market is anticipating a slowdown in economic activity. In most periods when the curve becomes inverted, a recession is typically not far behind.
As shown in the chart below, over the last ten years the yield curve and the S&P 500 have had an inverse relationship (we recently published a more detailed analysis for Bespoke Premium subscribers where we summarized the S&P 500's performance based on different readings in the yield curve). In late 2000, when the market and the economy were near their peaks, the yield curve was near its lows. As the economy weakened, the S&P 500 declined and the yield curve started sloping upwards.
While an inverted yield curve has been a reliable precursor of impending economic weakness, steeply sloped yield curves have historically been a sign that the market is anticipating strength in the economy (as was the case in 2002 and 2003). If this is the case, just as the market is now awaiting the NBER's official recession call, one year from now, we may be waiting for the NBER to say the recession has ended. The current difference between the yields on the 10-Year and 3-Month Treasuries is 360 basis points, which is near the highest levels of the credit crisis as well as the highest levels of the last ten years.
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