YIELD CURVE PLOTS THE DIFFERENCE BETWEEN LONG AND SHORT TERM RATES -- THE YIELD CURVE SUGGESTS AN UPPER LIMIT OF 3.75% FOR 10-YEAR YIELD -- THE GREAT ROTATION FROM BONDS TO STOCKS IS WELL UNDERWAY
COMPARISON OF LONG AND SHORT TERM RATES... I'm going to devote this message to an explanation of the "yield curve" -- what it is and how you can use it to determine the direction of bond yields and the stock market. During the financial crisis of 2008, the Fed lowered short term rates to zero which is the traditional method of combating a collapsing economy and falling stock market. When it couldn't lower short-term rates any further, it tried a more unconventional approach called "quantitative easing" which bought long-term bonds in order to drive long-term bond yields lower. More recently, the Fed has been talking about "tapering" its bond purchases which has pushed bond yields higher and bond prices lower. The Fed has vowed, however, to keep short-term rates near zero indefinitely. Which has led to the new Fed mantra that "tapering isn't tightening". Tapering would allow bond yields to move higher. Tightening would mean higher short-term rates. Which brings us to the yield curve. The "yield curve" is simply the difference between long and short term rates. Before showing you the actual curve, it's helpful to first look at a chart comparing long and short-term rates. Chart 1 compares the yield on the 10-Year T-Note (blue line) to the rate on the 3-month T-bill (black line). They generally trend in the same direction, but not at the same pace. During a period of economic weakness, short-term rates fall faster than long-term yields which is the result of Fed easing. That happened between 2000 and 2003, and again during 2008. During an economic recovery, short-term rates usually rise faster than long-term rates due to Fed tightening to combat inflation. That happened during 1994, 1999, and the period between 2004 and 2006. The danger point for the economy and stock market occurs when short-term rates exceed long-term rates (called an inverted yield curve). That happened in 2000 and again in 2007 (red circles). Stocks fell and the economy weakened in both instances. Our main concern at the moment is the period since 2008. To the bottom right, you can see the bond yield rising during 2013, while the short-term rate has stayed flat. That has caused the yield curve (the difference between them) to rise. Let's take it from there.
Chart 1
YIELD CURVE RISES... Stockcharts offers two versions of the yield curve. One is the difference between 10-year and 2-year yield ($YC2YR). The other is the difference between the 10-year and 3-month T-bill yield ($YC3MO). I'm using the second version here because of the Fed pledge to keep short-term rates near zero which, in my view, makes that version more relevant. Chart 2 shows what the difference between those two maturities look like (the yield curve). After dropping from 2010 to 2012, the yield curve started rising sharply this spring on hints of Fed tapering. [Since short-term rates have held near zero since 2008, all the ups and downs in the yield curve are being caused by movements in the 10-year yield]. We can use the yield curve to help determine an upper limit on how high the bond yield can go. That's because the yield curve itself has upper limits. Lower short term rates limit how high bond yields can go. Assuming the yield curve continues to rise over the next year (and short-term rates stay flat), a couple of upside targets are 3.55% (its 2011 peak) or 3.79 (its late 2009 peak). By subtracting the current 3-month rate from each of those two numbers, we get
potential upside targets for the 10-year yield at 3.48% and 3.72% (rounded off to 3.50% and 3.75%).
(click to view a live version of this chart)
Chart 2
BOND YIELD COULD REACH 3.75%... Chart 3 shows the sharp rise in the trend of the 10-Year Treasury yield since the spring. The yield backed off from the psychological barrier of 3% during the summer and pulled back to 2.5%, before bouncing again during November. I've taken the upper targets from the previous yield curve chart and overlaid them on this chart. Assuming short-term rates stay flat, those upper targets range from 3.5% to 3.75%. The 3.75% target is more technically significant because it represents the peak hit near the start of 2011. Chart 4 puts the 3.75% in better perspective by showing the falling trend of the 10-year yield since 2000. The chart shows that a rise to 3.75% during 2014 would bring the 10-year yield up to a falling trending drawn over its 2000/2007 highs. Chart 4 also shows that 3.75% is a 62% retracement of the yield drop between 2007 and 2012. That makes 3.75% a realistic upside target for 2014, if the Fed keeps short-term rates near zero.
(click to view a live version of this chart)
Chart 3
(click to view a live version of this chart)
Chart 4
THE GREAT ROTATION IS WELL UNDERWAY... There's a positive side effect to rising bond yields. When bond yields rise, bond prices fall. When bond prices fall, investors start moving money into stocks. That sequence supports the view that higher bond yields are already causing a generational shift in favor of stocks. Chart 5 plots a "ratio" of the S&P 500 divided by the price of the 30-Year T-bond. [A ratio is created by inserting a colon (:) between the two symbols ($SPX:$USB)]. The rising ratio between 1980 and 2000 favored stocks over bonds. The last decade favored bonds over stocks. Until now. The ratio actually bottomed during 2009. To the upper right, however, you can the stock/bond ratio exceeding its upper "channel line" drawn over its 2000/2007 (circle). That suggests that a generational shift is taking place in favor of stocks over bonds. In other words, the "great rotation" out of bonds and into stocks is well underway.
(click to view a live version of this chart)
Chart 5
OVERBOUGHT READINGS IN A SECULAR BULL AREN'T AS RELIABLE... Momentum oscillators tell us whether the stock market is overbought or oversold. But they have to be kept in perspective. During a secular bull market (a long term uptrend), the market can stay overbought for long periods of time. Chart 6 applies the 14-month RSI (red) line to the S&P 500 since 1980. The market reached overbought territory several times during the secular bull market between 1982 and 2000 and stayed there for years. The RSI line remained overbought during 1985 and 1986 as the market rose. During 1987, a major "negative divergence" in the RSI line (falling trendline) warned of a dangerous market condition which led to major stock selloff. [A negative divergence is present when the oscillator forms lower peaks while stocks are rising]. The RSI line also stayed overbought between 1995 and 1999 as the market rose. It took another major "negative divergence" during 2000 (falling trendline) to warn of a possible market top. During a secular bear market, which began in 2000, oscillators become more useful. Major oversold conditions in the RSI (below 30) during 2002 and early 2009 suggested major market bottoms. An overbought reading during 2007 led to a major market collapse. The circle to the upper right, however, shows the S&P 500 breaking out of its decade-long trading range which signals the start of a new secular bull market in stocks. In that environment, overbought oscillator readings are less relevant. First of all, the current RSI reading (while overbought) is still well below overbought levels reached during 2007, the late 1990s, and 1987. Secondly, there's no sign of a negative divergence. That doesn't mean that the market is immune from a downside correction (which is more likely during 2014 than this year). It does means, however, that overbought readings are less meaningful in a secular bull market. In a secular bull market (like the one we're currently in), the stock market can get overbought and stay there for a long time.
