A Dangerous Misconception

Ever since the echo bubble went into overdrive due to the Fed adding what by now are nearly $5 trillion to the broad US money supply TMS-2, while keeping the administered interest rate practically at zero, people have been looking for excuses as to why the latest bit of asset boom insanity will never end (few of them wanted to be long “risk” in 2009, but they sure are eager to justify their exposure now).

One popular theme gets reprinted in variations over and over again. Here is a recent example from Business Insider, which breathlessly informs us of the infallibility of the yield curve as a forecasting tool:  “This Market Measure Has A Perfect Track Record For Predicting US Recessions” the headline informs us – and we dimly remember having seen variants of this article on the same site at least three times by now:

“There are very few market indicators that can predict recessions without sending out false positives. The yield curve is one of them.

At a breakfast earlier today, LPL Financial's Jeffrey Kleintop noted that the yield curve inverted just prior to every U.S. recession in the past 50 years. "That is seven out of seven times — a perfect forecasting track record," he reiterated.

The yield curve is inverted when short-term interest rates (e.g. the 3-year Treasury) are higher than long-term interest rates (e.g. the 10-year Treasury yield).

"The yield curve inversion usually takes place about 12 months before the start of the recession, but the lead time ranges from about 5 to 16 months," wrote Kleintop in a recent note. "The peak in the stock market comes around the time of the yield curve inversion, ahead of the recession and accompanying downturn in corporate profits."

The Federal Reserve has been signaling that tighter monetary policy is on its way, which means short-term interest rates should move higher. Is this something we should be worried about? Kleintop offered some context:

How far the Fed must push up short-term rates before the yield curve inverts by 0.5% depends on where long-term rates are. Even if long-term rates stay at the very low yield of 2.6% seen in mid-June 2014, to invert the yield curve by 0.5% the Fed would need to hike short-term rates from around zero to more than 3%. Based on the latest survey of current Fed members that vote on rate hikes, they do not expect to raise rates above 3% until sometime in 2017, at the earliest…

Lots of economic and market factors drive what happens with interest rates. So the shape of the yield curve is definitely worth paying attention to. "The facts suggest the best indicator for the start of a bear market may still be a long way from signaling a cause for concern," he said.

This is it! The holy grail of forecasting, Jeffrey Kleintop has discovered it. You'll never have to worry about actual earnings reports, a massive bubble in junk debt, the sluggishness of the economy, new record levels in sentiment measures and margin debt, record low mutual fund cash reserves, the pace of money supply growth, or anything else again. Just watch the yield curve!

Unfortunately, this advice could turn out to be extremely dangerous for one's financial health. The idea is that the central bank normally begins to hike its administered rate, usually by following rising short term market rates. Long term bond traders foresee that this will sooner or later trip up whatever bubble is underway, and are buying longer term government debt in advance of the event – hence the yield curve as a rule inverts ahead of the bubble's collapse.

Except when it doesn't.

When Perfect Indicators Fail …

The so-called “perfect track record” Mr. Kleintop emphasizes is pretty much worthless once the central bank enforces ZIRP on the short end and has already begun implementing massive debt monetization programs. Here is a chart showing the relationship between 3-month and 10 year Japanese interest rates since 1989, with all six recessions since then indicated:

Over the past 25 years, the “perfect forecasting record” has worked exactly 1 out of 6 times in  Japan – and that was in 1989 – click to enlarge.

You may wonder what this has meant for stock market investors, so we have added the year-on-year change rate of the Nikkei to this chart. Here goes:

Year-on-year rate of change rate of the Nikkei since 1989. Ouch! - click to enlarge.

As you can see, there were numerous quite strong, playable rallies, interrupted by a series of wipe-outs ranging from 35% to almost 60% – and note, that is just the annual change rate, at one point cumulative losses exceeding 80% from the peak were recorded – in 2009, a full 20 years after the market had topped out!

On occasion of several previous interim lows in the index the cumulative losses from the peak ranged from roughly 65% to 78% (these were: 1992, 1995, 1998, 2001, 2003).

Only the first of the major interim market lows since 1989 (which was actually put in after the least worst decline measured from the peak) occurred after a yield curve inversion.

The Nikkei's manic top in 1989 and its subsequent wild gyrations - click to enlarge.

Conclusion

There is no “holy grail” indicator that can be used to make perfect economic and market forecasts. It is true that ifthere is a yield curve inversion, it definitely indicates trouble is on the horizon. Alas, we don't remember hearing many real time warnings (in fact, we don't remember any) from Wall Street analysts when such inversions actually occurred in the past (such as e.g. in 1999/2000 and 2006/2007), which makes this new preoccupation especially funny. Obviously, the only time to pay attention to this indicator is when it suggests that a bubble can keep growing!

However, there is no guarantee whatsoever that the yield curve will actually invert prior to the next economic recession and the echo bubble's demise. In fact, looking at  previous ZIRP and QE experiments, we would have to conclude that it is more likely that there will be no such warning at all. 

There is only one thing that is certain: things will continually change. There is no indicator that is fool-proof. If in doubt, one can always consult the Great Zoltar, or alternatively, do the opposite of what Dennis Gartman recommends. 

Zoltar has been in the forecasting business for a long time. He will know what to do and when.

Charts by: St. Louis Federal Reserve Research, BigCharts