Does The Flat Yield Curve Forecast A Weak Equity Market?

As the yield curve briefly inverted yesterday and the equity markets took a nose dive, a lot of news stories began linking the two events together.  But for every story about the predictive powers of the yield curve, you can read another one about how it doesn’t mean anything to the equity markets.  So which is it?  Does the inverted yield curve actually forecast a weak equity market?

Wouldn’t you know it, the answer is both yes and no.  It all depends on which time period you examine.  I have looked at the relationship between the yield curve and the stock market back to 1953 and have broken that time period into three sections. 

The first period, from 1953 to about 1977, shows that the yield curve was indeed a very good predictor of the equity market.  In the following chart, I have shown the spread between the 1 year and 10 year treasuries (a value below 0 indicates an inverted yield curve) and the year over year change in the S&P 500, set back 12 months.  You can clearly see a high correlation between the yield curve and the changes in the S&P 500 until about 1977, when the releationship begins to break down. 

The second period between 1980 and 1999, shows very little correlation at all between the yield curve and the S&P 500 set back 12 months. 

The last time period is between 1999 and 2005.  Although it’s far from perfect, you could make the argument that the yield curve has begun to lead the market once again.  For 30 years, the two had a strong relationship and it could be returning once again.

The real question becomes why the yield curve has lead the equity markets in the past and why it stopped doing so in the 1980s and 1990s?  Several explanations such as 1) lower tax rates, 2) lower trending interest rates, 3) higher debt levels and increased liquidty, 4) a more activist Fed, and 5) a stock market mania, could all be the causes for the lack of correlation during this time frame. 

Now that overall debt levels are at their highest point in history, the equity markets could once again be more closely linked to the changes in the yield curve, making the yield curve more relevant today than it was over the past 20 years.   Therefore, the correlation could be returning. 

These of course are spurious arguments that are difficult to prove.  However, its clear that at one point in stock market history, the yield curve was an excellent predictor of future equity market performance.  Whether or not that will be the case in the future remains to be seen.