For the past few years, the stock market has been bullet proof. Nothing from the occasional misstep from blue chip companies such as IBM, to whole sectors such as retail coming under pressure, or the very real threats of nuclear missiles from North Korea has been able to stall the continuous rally.

But the one item that many market veterans agree could derail the bull market would be a substantial rise in interest, which would make current stock prices seem very expensive on a discounted cash flow valuation basis.

But another scenario where the bond market could be a harbinger for a downturn in stock prices would be a flattening of the yield curve, which often precedes a recession. Today’s investing advice will explore this possibility, and the problems it could cause.

Gaving over at OptionsTrading break it down for us here.

Yield curves are something I like to keep a close eye on, particularly towards the end of a long bull market, as they are a great predictor of economic downturns.  A yield curve refers to the difference in yields between long term and short term yields.  The risk of default is greater over a longer period of time, so long dated bonds typically have a higher yield than shorter dated bonds from the same issuer (e.g. the US government).  Occasionally, yield curves will “invert”, which is where short dated bonds have a higher yield than long dated bonds.

Normal yield curves (upward sloping, not inverted) as a sign of economic health.  Banks can generate a profitable interest margin by borrowing at cheap short term rates and lending and the higher long term rate.  This margin, encourages banks to lend and as such stimulates economic activity.  When the yield curve inverts, banks will contract lending and economic activity will stall.

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I don’t have empirical data, but when an inverted yield curve occurs, the majority of time a recession follows soon after.  Cullen Roche from Pragmatic Capitalism noted the following in his June 2011 post:

“Richard Bernstein’s Merrill Lynch note from 2006 is burned into my memory.  I’ll never forget his recession call in the USA based on the inverting yield curve.  The note said something to the extent: “a profit recession has occurred 100% of the time following an inverted curve”.  Recessions, though not 100% accurate based on the yield curve, remain very high probability events when confronted with an inverted curve.  And this makes a great deal of sense.  An inverted curve is generally a sign that a credit binge is coming to an end and banks and investors are beginning to reign in their risk while also generally being accompanied by tighter government policy.  An inverted curve is the equivalent of reaching the point where you’re slamming the breaks on the car trying to stop her.  And it generally works!”

Right now the yield curve is the flattest it’s been in over a decade.

Generally, when a yield curve inverts, it is because of rising short term rates.  However, in this current environment environment, short term rates are zero and likely to stay there for the immediate future.  What is interesting however, is the fall in 10 year yields.

10 Year yields are at historic lows around 1.50% and as a result bank margins are going to be squeezed.  The market seems to be cheering for the Fed to come to the rescue with QE3, but that will likely drive down the 10 year yield even further.  In this fragile economic recovery, I don’t think we want to see another lending contraction which may well be an unintended consequence of QE3.  So, think twice before you start cheering a continued low long term rates, as the consequences could be dire.

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