The dynamic yield curve
Some of you probably heard about the dynamic yield curve, or maybe not, but I think it is an interesting tool to understand the interactions between bond and stock market.
It is a common thinking that the stock market anticipates the economic cycle, but I will show you that the real driver is the bond market.
Don’t you believe it?
First of all, what is the dinamic yield curve?
It is the graphic representation of the yields and the duration of all the US government bonds.
On the y-axis (vertical axis) there are all the percentage yields from zero to 5%, and on the x-axis (horizontal axis) the duration from 3 months to 30 years.
This could be a simple representation.
As you can imagine, this structure is correct because you have less profit for shorter durations and higher bond yields for longer durations.
Is the curve like that always?
The answer is NO! This is the real issue!
The curve can also have irregular trend.
It can be FLAT. In this case the short and the long-term performance are equal.
Otherwise it can be REVERSED.
In this case the profit of the short period is even bigger than in the long term.
Why does the curve take this unexpected trend?
The short-term rate governed by the central bank has an x value of 3% for example.
The rate value at the end of the curve should be greater than 3% because during an economic growth the market must be paid for the expected inflation tax rate.
If in the long term you have equal or less profit then in the short term it means that the brokers do not expect inflation, as a result there will not be economic growth.
This is the main reason why the inversion or flattening of the yield curve indicates the approach of an economic recession.
This situation always precedes the drawdown that will occur in the stock market and this is why it is an interesting index.
The comparison between the dynamic yield curve and the performance of the S&P500 shows that the curve flattening comes few months before the stock market drawdown.
In 1999 a few months before the drawdown of the S&P500, the dynamic yield curve was almost flat.
In 2006, one year before the new drawdown of the S&P500, the dynamic yield curve was flat again.