As investors, we are always looking for tools we can use to get clues about what is going to happen in the stock market in the future. After all, the more corroborative information you have about investor sentiment and economic strength, the easier it is to make informed trading decisions. One of the most reliable tools analysts have turned to for decades is the Treasury yield curve.
The Treasury yield curve is a graphical representation of the yields of all currently available Treasuries — from short-term notes to long-term bonds. You can see an example of the Treasury yield curve as of Halloween in Fig. 1.
Fig. 1 — Treasury Yield Curve (source Treasury.gov)
Shorter-term Treasury yields are plotted to the left of the chart, and longer-term Treasury yields are plotted to the right of the chart, with the time until maturity represented along the X-axis and the yield each Treasury is generating represented along the Y-axis.
Typically, the Treasury yield curve will slope upward from left to right, as shorter-term Treasuries usually provide lower yields, while longer-term Treasuries usually provide higher yields to compensate investors for the greater inflation risk they are taking on by buying a longer-term asset.
We say the Treasury yield curve typically slopes upward from left to right because it doesn’t always do so, and sometimes the slope is more dramatic than others. By watching the slope of the yield curve, you can get clues regarding what bond traders believe is happening in the economy.
When it comes to watching the slope of the Treasury yield curve, you are basically looking to see if the curve is “steepening” or “flattening.”
A steepening yield curve generally indicates that bond traders believe the U.S. economy is going to experience greater inflation (typically driven by strong economic growth) in the future, which leads them to demand a higher yield on their bond investments to compensate them for the additional risk they are taking.
You can see a great example of a steep Treasury yield curve in Fig. 2, where the difference between the 1-month Treasury yield (0.01%) and the 30-year Treasury yield (3.92%) is 3.91%.
Fig. 2 — Steep Treasury Yield Curve (source Treasury.gov)
When you compare the steepness of the Treasury yield curve in Fig. 2 with the steepness of the Treasury yield curve in Fig. 1 — where the difference between the 1-month Treasury yield (0.99%) and the 30-year Treasury yield (2.88%) is only 1.89% — you can see that the Treasury yield curve isn’t nearly as steep now as it was in early 2014.
The flattening of the yield curve during the past few years indicates that bond traders don’t believe inflation is going to be much of a risk in the future.
Sometimes, the Treasury yield curve flattens so much that it becomes inverted, where the short-term Treasury yields are higher than the longer-term Treasury yields. You can see an example of this on the Treasury yield curve in Fig. 3, where the difference between the 1-month Treasury yield (5.05%) and the 30-year Treasury yield (4.90%) was -0.15%.
Fig. 3 — Inverted Treasury Yield Curve (source Treasury.gov)
Inverted yield curves are a warning sign for the stock market because, while not every recession has been preceded by an inverted yield curve, almost every inverted yield curve we have seen in the past 40 years has been followed by a recession.
So how do things look right now?
You can see in the Treasury yield curve chart in Fig. 4 that the yield curve has been flattening since the bullish surge that followed the Presidential election.
Fig. 4 — Treasury Yield Curve Comparison (source Treasury.gov)
The front end of the Treasury yield curve has been rising, while the back end has been falling.
We’re still quite a ways away from the yield curve becoming inverted, but we are seeing it flatten out, which is a warning sign that long-term economic growth expectations among bond traders are waning.
The U.S. Treasury market is going to fluctuate in the aftermath of today’s Federal Open Market Committee (FOMC) monetary policy meeting. Watching how the Treasury yield curve responds — whether it steepens or flattens — will tell us a lot about longer-term economic expectations.
If the yield curve steepens, watch for a more bullish lift in the stock market. If it flattens, watch for the bullish uptrend we’ve been enjoying in the stock market to be tempered somewhat.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.