Can Yield Curves Predict Market Plunges?

In the final days of December 2005, there was much ado about 2-year Treasury bond yields moving above 10-year yields for the first time since 2000. Analysts warned that this was the beginning of an inverted yield curve that had ominous implications for US stock markets and the economy in 2006. The last time such an inversion began to occur was in February 2000, and over the next 30 months, the Nasdaq dropped 80% and the Dow fell nearly 35%.

But how accurate has an inverted yield curve been in the past in warning about trouble ahead? And if it is a good indicator, what combination of yield relationships has the best record in providing a heads-up of a market change? "Economists and analysts tend to be obsessed with forecasting the next recession,"notes Darrell Jobman of TradingEducation.com. "However, like the captain of a ship who alters course after the ship has been struck by a torpedo, by the time a recession is upon you, most of the damage to your portfolio has already been done. Wouldn't it make better sense to develop a strategy to avoid bear markets?"

Looking Back to Look Ahead

With this in mind, let's see if various combinations of yield relationships have provided advance warning of bear markets in the past. A complete inversion occurs when the 3-month (13-week) Treasury-bill yields rise above 30-year yields, but this usually occurs last. Instead, let's look at the 10- year minus 3-month, then 10-year minus the fed funds rate, and 10-year minus 2-year rates (the inversion that caused the commotion in late December), to find the best indicator.

Does the Curve Work?

Based on the chart evidence, an inverted yield curve did provide advance warning of impending bear markets at least 50% of the time, but it is also important to point out that in a number of cases (five in Chart 2 and two in Chart 3), bear markets occurred without an inversion warning.

So, while not perfect, when an inversion occurs between either the 2- year yield or fed funds rate and the 10- year yield, it's time to pay attention. The chances of a bear market have risen above 50%, and your portfolio is at greater risk.

Matt Blackman, market analyst for Trading

Education.com, is a technical trader, author,

and keynote speaker. He is a Market

Technicians Association affiliate and a member

of the Canadian Society of Technical

Analysts. For more information, visit TradingEducation.com.