The Yield Curve: A Route to Better Investment Decisions
by Deborah Weir
Did you ever do all the right homework, analyze financial statements, calculate price-earnings ratiosand still lose money because the economy changed and earnings fell?
If you have had that kind of unhappy investment experience, you are most likely in need of a tool that can help you identify major changes in the economy that will change a companys fortunes. And you would prefer a tool that is free to the general public and easy to use something that requires no math.
If that tool can help you forecast the general direction of the stock market, which is simply the aggregate of all publicly offered firms, so much the better.
Fortunately for individual investors such a tool does indeed exist: the U.S. Treasury yield curve. And it is powerful, deserving regular mention in the Federal Reserves literature.
The U.S. Treasury yield curve can help you find major changes, or turning points, in the economy that will affect your investments fortunes and determine the course of the stock market as a whole. It will simplify your investment decisions, make it easier to stand by them, and help you sleep at night.
Many investors are in fact familiar with the yield curve but have not paid much attention to it. This article will reacquaint you with the yield curve, show you what it can do for you, and tell you where you can find itfor free.
What Is the Yield Curve?
The yield curve is a reflection of millions of investors decisions, which are influenced by their outlook for the future. They take this opportunity to lend money to the U.S. government for any period of time from overnight to 30 years.
Suppose they all want to buy a new car next year.
They could save for that car with a one-year Treasury bill or by rolling over one-day bills. Some of them bought a six-month bill with the intention of renewing it at maturity. Their decision to save with one-month, six-month, or one-year bills depends on their outlook for interest rates.
Those who expect rates to increase during the year stayed in short-term investmentsin this case, one month. On the other hand, those who think that rates may fall bought the longer security. The yield curve is a picture of peoples views on the future course of interest rates.
This curve, as its name implies, is expressed in the yields that investors receive rather than in the prices that they pay. Prices and yield are the inverse of each other. The more you pay for any asset the less return you can realize on it.
For example, if you bought your house 10 years ago at a low price, you will get a high return, or yield, if you sell it today. Your neighbor who bought his at the top of the market, however, paid such a high price that he made it impossible to get a good yield if he sells his house today. We speak in terms of yield rather than price in the fixed-income market because people buy these assets for the return, or yield, they can earn.
What Can the Curve Reveal?
The yield curve can forecast the economy about one year ahead.
The shape of the curve reveals what investors think will happen. So many people participate in this marketincluding the Federal Reserve and the U.S. government who drive the economythat their expectations are self-fulfilling. There are two basic shapes of the yield curve. Each one matches an economic forecast of either expansion or contraction.
The most common shape of the yield curve is that of a line that slopes up. This is called a normal, or positive, curve and relates to an economic expansion. The graph in Figure 1 is an example of a normal curve.
The longer you lend your money to the government, the higher the yield you receive. It is only fair that you receive more income if you give up the use of your money for 30 years rather than just three months. A normal yield curve also means that investors expect interest rates to rise, as in the example of saving for a new car. Otherwise, people would buy the longest-maturing bond that they could.
In fact, thats exactly what they did in August 2000. People thought that there might be a recession and that interest rates might fall, so they bought long-term bonds. They bought so many of them that prices went way up and yields declined all along the curve. We had a downward-sloping, or inverted, curve (see Figure 2).
One year later, we were in a recession and many people had losses in their portfolios. The recession was no surprise to those who knew that the Fed and the U.S. government are large players in the Treasury market. When these rule-makers decide to slow things down, they get their way.
This year-ahead relationship between the shape of the curve and the condition of the economy occurs often enough for the Federal Reserve to report on it in their free monthly brochure, Economic Trends (see Figure 3). Notice how the black line for the economy moves in tandem with the red line. The red line is the difference between the three-month and the 10-year Treasury securities. That spread moves up as the economy expands and moves down with contractions.
Since business owners must borrow to pay their expenses, it stands to reason that interest rates move up and down with economic activity. Business is affected by the Federal Reserves changes in the level of interest rates. It takes about a year for economic activity to catch up. The stock market, however, reacts immediately.
The S&P 500 index almost always declines on the day that the yield curve inverts from the three-month bill to the 10-year note. It then tends to rally on the day that the curve returns to normal. Small, flexible traders who watch the market every day profit from this information. They have an advantage over large institutions that must move more slowly.
Figure 4 shows a graph of the S&P 500 index with arrows pointing to the dates that the curve changed shape. You can see from the arrows that the changes in the yield curve immediately preceded some of the worst stock market declines, and most of the rallies from 1960 through 2004.
Can the Yield Curve Help Your Stock Selection?
Knowing that the economy is ready to change can have a profound impact on your stock selection. Many of the screens that investors use to choose these stocks depend on the past growth of revenues and earnings. This data, however, changes throughout an economic cycle. A firms history of earnings growth may be ready for a big change with the onset of a recession, and you want of be on the right side of that change!
A case in point is a firm in the computer hardware business during the late 1990s.
The economy was expanding and orders flowed into Sun Microsystems (SUNW). But when the century turned and the economy declined, so did their customers need for new computer hardware. Their annual report shows that net income declined in 2001 and again in 2002; their stock price fell from $39 to $3 during the period. Investors who sensed a recession coming could have factored reduced revenues into their analysis.
On the other hand, home-building stocks were unpopular during Suns heyday at the end of the century. People were putting their money in the stock market in the hopes of realizing quick profits. Home builders like Lennar (LEN) were unpopular because of their slow profit growth.
That changed, of course, when investors took their money out of the stock market and rewarded themselves with something they could actually enjoy. They built new houses, which increased the earnings at Lennar. As a result, Lennars stock price tripled while Suns crashed.
Again, having the ability to forecast the economy helped investors adjust their earnings estimates.
Where Can You Find the Yield Curve?
Now that you understand this powerful tool that has the backing of the Federal Reserve, and you have seen what it can do for your stock selectionwhere can you find it at a reasonable price or, better yet, for free?
The Federal Reserve is a source of free data and, depending on the source, interpretation. Because the yield curve is one of the variables that the Fed uses to forecast the economy, you can find data on two of the district banks Web sites.
The Cleveland Fed includes the three-month/10-year spread in their monthly report Economic Trends. You can subscribe to a hard copy or download it (see the Sources of Information box for addresses and Web sites). This district bank includes yield curve information only when it relates to their accompanying text.
For regular monthly updates, refer to the district bank in Dallas. The Dallas Fed includes graphs of the three-month and the 10-year yields in their weekly on-line Quick Slide Show on the U.S. Economy (page 6 of the condensed version). Both Fed sources, as mentioned before, are free.
Bloomberg.com is also free. On their interest rate page they give the raw data and a graph of the prevailing and previous curves. This is an excellent resource because it is in real time, so you can get current market updates with a short time-lag.
Inexpensive print sources include the Wall Street Journal and USA Today. Each of these newspapers provides the closing yields of benchmark Treasuries such as the three-month, 10-year, and 30-year. The Wall Street Journal also gives you previous yield curves for comparison and a complete list of all the Treasury securities in the market. Other newspapers print Treasury yields as well, so you have many inexpensive resources for this important data.
Now you know more about the yield curve and why it is important. You know how it can help you forecast the economy and the stock market, and you can use that forecast to adjust your earnings estimates for stock selection.You know free and inexpensive sources of reliable information on the Treasury yields.
When you do your stock selection homework, you will be more confident in your results. You will stick with your decisions and sleep better at night.
|Sources of Information|
Cleveland Federal Reserve
Dallas Federal Reserve
Wall Street Journal