Tuesday, October 7, 2008

The yield curve

The yield curve can give a general signal about whether times are good or bad, much like the Dow to Gold ratio. Without getting into too much economic mumbo jumbo detail, a general assessment of the stock market "weather" can be obtained by the yield (in percentage terms) of a longer dated government bond divided by a shorter term government bond. The chart below is a ratio chart consisting of the yield of the ten year U.S. government bond divided by the yield of the 90 day U.S. government bond (called the "Treasury bill" or "T bill" if you want to sound cool).

In "good" times, the ratio of the longer term rate divided by the shorter term rate declines, while it rises during a contraction (i.e. the "bad" times). When the bull market gets a little overzealous and everyone starts to speculate too much, the phenomenon of yield curve "inversion" can occur, which is when the short term rate goes higher than the long-term rate, which causes a ratio of less than one on the chart above. Once the yield curve inverts, the bull market top should occur within about a year or so, giving longer-term horizon investors plenty of warning that the good times and the current bull market of the day will be coming to an end. This time around was no different.

Wikinvest Wire