Treasury Yield Curve

Low interest rates pose a major concern for the current market environment, especially as far as rotation strategies are involved. As witnessed by the chart of the 10-year U.S. Treasury Note (^TNX), we've been in a general environment of declining interest rates since the early 1980's, which also has been fueled by the dovish monetary policy of the Federal Reserve over recent years.

The reason this poses a concern is that once the Federal Reserve determines that it will no longer continue its quantitative easing policy, interest rates should start to rise. Especially the bond market will likely be adversely affected by this. Many of the rotation strategies don't have a cash-stop, but rather use (long-term) U.S. Treasuries as a safe-haven when stocks start to underperform. However, in a rising rate environment, especially long-term bonds may no longer act as a safe-haven in case of a pullback, correction or a prolonged bear-market. Therefore it becomes crucial to know when rotation strategies may no longer perform as expected (i.e. when to get out). Even with a buy-and-hold strategy, a typical 60/40 or 70/30 stocks to bonds allocation may no longer work to minimize portfolio drawdowns in a rising rate environment.

I recently came across this chart, provided by LPL Financial Research. It shows how, since 1967, treasury yield curve inversions have marked stock market peaks before a downturn and recession.

Though surprisingly accurate, the yield curve sometimes gives a signal way before the correction, e.g. August 2006 signaled a downturn, which didn't actually start until October 2007.

This made me wonder that maybe if I combined the indicator with the "AdvDecnCumAvg" indicator that I provided a few posts ago, I'd get a more robust signal system.

I analyzed all U.S. bear markets since 1966, listed at Gold-Eagle. Though not an official bear market (> -20%), I also included the correction of July 1990 - October 1990 (~ -15%), which was predicted. Both indicators gave a false positive in December 1978 and the Black Monday crash of 1987 was not predicted. There was no AdvDecn data available for the first bear market of 1966, but the yield curve signaled the downturn very accurately.

Occasionally the yield curve would provide the first signal (yellow), and at other times AdvDecn would provide the first signal. The second (green) signal acts as the final trigger signal.

Though admittedly not that many data points, existing data would suggest that when using these two indicators in conjunction with each other, assuming historical data applies in the future, we can somewhat accurately predict a future major downturn in the stock market without leaving too much on the table by running to the fences prematurely.

A glance at the treasury yield curve today, on May 18, 2015, along with the AdvDecnCumAvg, would suggest that a major market correction isn't looming behind the corner, yet. Please find the link to the automatically updating Google Sheet below.

QH U.S. Treasury Yield Curve