Experts Incorrectly Use This Indicator To Spread Fear

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One indicator predicted every recession for the last 50 years.

It’s not magic, a closely held secret, or deep math. In fact, the Federal Reserve publishes the data for everyone to see.

And this one indicator might even be top of mind for you, as it was in the news just last week… But you can’t just read a headline like that one (from Yahoo News) and dump every equity you own.

In fact, our TradeSmith market outlook tool says most major markets are extremely healthy. That’s why you need to understand what the yield curve is, how to interpret it, and what it means when it inverts.

Because within this scenario are some incredible opportunities.

What is the Yield Curve?

Let’s start with a simple premise. The longer you lend money, the higher the interest rate you should charge, with all else being equal.

Intuitively, that makes sense.

If you tie up your money for a long time, you want to see a better return, because you’re taking on a lot of risk. Think of all the investments you can’t enter because you lent out those dollars.

Government debt works the same way.

The U.S. government issues debt with varying maturities, or due dates.

Typically, the longer the time until maturity, the higher the interest rate.

That leaves you with a curve looking something like this.

How to Interpret the Yield Curve

Changes in long-term and short-term interest rates are what cause the yield curve to steepen, flatten, or remain stable.

Let’s look at steepening yield curves first.

In the first scenario, long-term rates move more than short-term rates.

In the chart below, you can see how the interest rates on the longer-dated maturities (the green line) are higher than the interest rates on the shorter-dated maturities. Long-term rates will rise faster than short-term rates when investors expect the Fed to hike interest rates in the future.

In the second scenario, short-term rates rise faster than long-term rates. In this situation, the market expects the Fed to cut rates to spur demand. This is a boon for equity markets, as we’ve experienced over the last decade. Yield curves can flatten as well.

When long-term rates fall faster than short-term rates, markets expect the Fed to raise short-term interest rates. And when short-term rates fall faster than long-term rates, the market expects the Fed to cut short-term interest rates.

So what causes a flattening versus a steepening?

Generally speaking, the yield curve gets steeper when investors have a positive outlook for the economy, while it gets flatter when investors see a recession or poor economic environment on the horizon.

The Dreaded Yield Curve Inversion

Now we get to the yield curve inversion.

A yield curve inversion occurs when any interest rate on the short end of the curve exceeds any rate on the long end of the curve.

For example, if the two-year yield is 2% and the 10-year yield is 3% to begin with, and we see the two-year yield jump to 3.5% while the 10-year remains unchanged, this is known as a yield curve inversion.

I want to point out that there are many different ways to measure a yield curve inversion.

The thing is, U.S. Treasury debt has maturity dates ranging from a few weeks to 30 years.

So, it’s possible to have the two-year yield higher than the 10-year yield with both still below the 30-year yield.

That’s why it’s important to look at several different levels of the inversion to get a complete picture.

The Federal Reserve Bank of New York provides some great data points and charts to help.

One of my favorites is the spread between the 10-year bond and the three-month bill rate. While not popular, this indicator has predicted every recession since 1970. In this chart, you can see the difference between the 10-year interest rate and the three-month interest rate (aka the spread) plotted since 1960. The gray vertical bars represent various recessions over the years.

Notice how the spread dips below zero for every recession. That’s where it becomes helpful as a possible indicator for an upcoming recession.

True, it sometimes goes below zero without a recession, so it can provide a false positive. But for every recession on that chart, there was a negative yield curve closely preceding it.

Looking at the chart above, the current spread is well above zero, so that’s a good sign that we’re not heading into a recession.

Another more popular indicator is the spread between the two-year and 10-year yield.

Similar to the graphic above, the chart below lays out the 10-year yield minus the two-year yield over time, with gray areas highlighting recessions. Again, this indicator says we shouldn’t expect a recession anytime soon.

So, where exactly is the problem?

As I mentioned earlier, several media outlets, including Bloomberg, recently reported that the spread between the 20-year and 30-year interest rates had turned negative. That is definitely true.

However, as you can see, this isn’t as reliable a predictor as the other spreads have been. There are multiple instances where the curve has gone negative or even remained negative for years at a time without a corresponding recession.

Looking at all the indicators available, most are projecting a stable or even healthy market, while only one points to a possible recession in the near future.

You Mentioned Something About Opportunity?

Indeed I did. We know three things for certain:

• Supply chain issues aren’t going away anytime soon.
• Demand continues to outstrip supply.
• There is an increasing likelihood that the Fed will raise rates sooner rather than later.

All this points to one sector with enormous potential: banks.

No, they aren’t sexy.

But they make a killing when interest rates rise.

You see, banks borrow at the short-duration end of the yield curve (lower rates) and lend at the long-duration end of the yield curve (higher rates).

A steeper yield curve means more profits to the banks in the form of net interest margin (NIM).

But let’s take that a step further.

Certain banks derive a large portion of revenue from net interest margin, while others earn their profits from activities like trading and wealth management.

Regional banks often do more lending than large money centers. That’s why stocks within the S&P Regional Banking ETF (KRE), which has been in the TradeSmith Finance Green Zone for more than 10 months and last week hit a recent high, outperform when yield curves steepen.