Time Frame: Long
Category: Monetary

Description

The yield curve is the relationship between short-term interest rates and long-term interest rates. Normally, the yield curve is upwardly sloping reflecting higher yields on longer maturity bonds. Since the issuer of a bond is not obligated to pay the par value of the bond until maturity, the holder of the bond assumes the possibility of incurring a loss in nominal and/or "real" dollars. A nominal loss is incurred when the bond is sold at a capital loss. A "real" dollar loss occurs when the fixed income return is less than inflation. Longer maturities increase the possibility of incurring a capital loss and/or inflation diverging from its expected rate causing a "real" loss. Therefore, longer maturity bonds carry more risk which is normally compensated for with a higher nominal rate of return.

When the yield curve becomes inverted (short-term yields are higher than long-term yields) it is invariably bearish for stocks. An inverted yield curve may be caused by an unusually high demand for short-term funds (a near-term liquidity problem in government or business), a surge in short-term inflationary pressures, or a very restrictive monetary policy by the Federal Reserve. All three instances - liquidity problems, inflation and tight monetary policy, have negative implications for the economy and the stock market.

Calculation & Significant Levels

Yield Curve: The yield on the 30-year treasury bond minus the yield on the three-month T-Bills. When the yield curve spread is greater than 3.5% (very steeply upward sloping) it is bullish for stocks, and when the yield curve is negative (inverted) it is a bearish indication for stocks.

Formula: (Long Bond yield) - (T-Bill yield)

Gauge Elements: Magnitude
Updated: Weekly (as of Friday close)

Strategy