One of my favorite market indicators is our yield curve model. It has warned us several times in advance of significant correctionsthis year.
Warnings over the past few years have included:
July 16, 2018: The Yield Curve Update – We were a little early. SPX closed at 2798 that day, rose to 2940 before crashing 20% by Dec 26. The final 13% was signaled on Dec 5: The Yield Curve’s Warning.]
April 25, 2019: The Yield Curve Model Warns Again – SPX gained 21 points over the next four sessions before quickly shedding 226 points.
February 20, 2020: Buckle Up – SPX (which had topped out the day before) crashed by over 35% over the next month.
August 25, 2020: Update on AAPL – We were about a week early, but the model signaled a correction which saw SPX fall 11%, followed by another 9% the next month.
The recent breakout of the 2s10s is clearly a bearish signal – though it hasn’t yet paid off. Is the model still working? First, a little history. Among other things, the model holds that breakouts above significant resistance are bearish for equities.
If we plot the 2Y and 10Y together, we can see that significant sell-offs in stocks were marked by more rapid declines in 2Y yields than in 10Y yields (i.e., a widening of the spread between the two.)
The shaded areas below illustrate the period during which stocks experienced their most significant corrections between 2000-2013. Though the 2Y and 10Y both declined during these periods, the 2Y yields clearly fell faster.
But, as we saw in 2015-2016 and again in late 2019, not all corrections involved a steepening. These selloffs occurred without the yield curve model signal being triggered. Did the model stop working? Hardly. The decline earlier this year was a stark reminder of its predictive power. What made these corrections different? More importantly, what is the model signaling now, and how likely is it to play out?
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