The Yield Curve Knows Best

Caroline Baum has an article on one of the best economic forecasters out there. His name is Dr. Yield Curve.

The yield curve, or spread, has several things going for it: First, it’s a leading economic indicator, officially added to the index designed to predict the economy’s ebbs and flows in 1996. It was a leader well before that, even though it was unofficial.

Second, what you see is what you get. The spread is never revised, always available and in no way proprietary.

Third, and most curious, the majority of economists don’t get it. They see rising bond yields in isolation -- without paying attention to what that price-setter, the Fed, is doing at the front end of the curve.

It’s the juxtaposition of short and long rates, not their level, that conveys information about monetary policy.

In a July 2008 working paper, San Francisco Fed economists Glenn Rudebusch and John Williams examined the tendency for professional forecasters to ignore the spread. They compared the forecasts provided by the Survey of Professional Forecasters (SPF) to that generated by a simple, real-time model based on the yield spread.

Guess who won? And it wasn’t even close.

Two years ago, I looked at the impact of the yield curve on the stock market and I was stunned to find:

Probably the most fascinating stat is that all of the stock market’s net capital gains have come when the 10-year yield is 65 or more basis points above the 90-day yield (that happens about 70% of the time). The yield curve hasn’t been that positive in 15 months.

Anything less than 65 basis points, including a negative yield curve, works out to a net equity return of a Blutarsky. Zero Point Zero.

Today the spread is out to nearly 300 basis points.