The 10y-2y bond yields are important because it is the long-short of market expectations; that is, how people view the near-term market vs. their perceived evolution of the market (that also anticipates the FOMC's likely reaction. It's several signals in one). The 10y2ys (blue) is the 10 year Treasury constant maturity (now at 0.96%) Minus the 2-Year Treasury constant maturity (now at 0.19%). When the spread increases, it means there's falling demand for long-term Treasury bonds, which means investors prefer higher risk, higher reward investments. Investors think interest rates will now rise in the short term.
Currently, the 10y-2y is at 0.8 and rising which last happened in December 2007, April 2001, December 1990, July 1986, October 1971... you get it. It's a reliable indicator, and in the past, a negative 10-2 spread has predicted every recession from 1955 to 2018 (SOURCE), but has occurred 6-24 months before the recession occurring. The last time it went negative was in August 2019.
THE ANALYSIS Notice that we're approaching a golden cross (yellow 50ema crossing the white 200ema). The last time this happened was January 2008, and May 2001. I've overlaid the S&P- you can see it's crashed.
So is this a new paradigm of monetary policy? Or does nothing change? Is this time really different?
MORE ABOUT THE YIELD CURVE Bond prices and yields move inversely of each other. When bond prices go up yields go down, and vice versa. The reason that lower yields in the long term are a indicator for the economy is because longer term bonds are seen as safe investments meant for preserving wealth; while stocks, forex, and derivatives are riskier and used for growing wealth. When investors have a good outlook on the economy, they will sell their long term bonds and put that money into the riskier investments listed above. This flight from longer term bonds to riskier investments causes demand for the longer term bonds to fall, causing bond prices to fall ,and yields to increase. In times of bad economic outlook, people will start moving their money from stocks into the longer term bonds as a way to protect themselves from potential future downturns. This flight from stocks to longer term bonds causes demand to increase, causing bond prices to increase, and yields to go down. The change in bond yields is based on bond price, which is based on supply and demand .
HISTORICAL CONTEXT: The 10-2 spread reached a high of 2.91% in 2011, and went as low as -2.41% in 1980. During recession, central banks lower rates pushing down the i.r. curve. When the spread starts contracting, market expects a coming cut of the i.r. and a future lower curve. For this reason, real world curves (vs academic ones) are decreasing on the long terms: a kind of economic cycle is implied. You may also read the spread under a credit risk point of view: a tight spread means "if an issuer can survive 2y, it is very likely that it will survive also 10y therefore a small extra premium is required". This is very clean in distressed bond issuers: implied yields usually form a reversed term structured (decreasing like an hyperbola).
@TMoneyBidness This looks extremely logic and legit and is very compelling just to ignore, however I got interested in your other charts and man, I have to say, you kinda almost had 1 correct prediction out of 10+ charts. Vaccine hopium and the positive statistics post US elections could mean further upwards move to 4k at least.
TMoneyBidness
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@badbeatnuts, Totally fair, haha. Lots of mistakes, but 1/10? That's harsh man. More like 1/2. I'm very confident in my abilities now. Looking back on some of those trades, some were incorrect analysis, but the other stuff was big market macro stuff that changed and I would adapt. My stuff on the airlines was dead wrong, I went opposite the big tech run. I mostly post stuff that I'm interested in to check back in later, and keep my high conviction stuff to myself now.
badbeatnuts
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@TMoneyBidness, I understand, I too made big mistakes like trying to short the rising SPX in april/ may between the 2850-3100 zone several times only to get burned each time. Looking back, I still don't find sense in it not going under and if I have to be honest - I currently don't think it can go down so the contrarian in me is saying not to trust my initial instincts and to bet against my feeling.
Your chart is big market macro stuff which is out of my league as I tend to trade foreseeable next moves based on price action in the short-term through wave analysis. However, I have to note that looking at macro indicators like Shiller Crash Index, Valuation Confidence Index, Schiller PE ratio, things are stacking up on the short side of the Force.
SarahTrade
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Interesting, thanks for sharing. I don't think a recession is going to happen through. Historically, there was no QE in the US before 2008. As a result it took a long time for the market to recover from the 2000 crash. US tried its first QE1 after the crash in 2008. Back then nobody knew how effective it was so it again took a few years for the market to recover. But it is very different this time: having seen the effects of QE1,2,3 over the years, everybody knows that the fed will bailout the market for sure and that the market will keep going higher because of new QEs. As soon as the fed took action and announced QE4 in March 15, the market reacted instantaneously. QE4 has been absorbed by the market and we've seen the index flattening in recent months. Right now people are just waiting for the fed to confirm the next stimulus check. We may see something like the dip at the end of 2018 but a big crash followed by a long recession is not likely to happen again.
Hedge_Of_The_World
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Excellent work. I couldn't have said it better myself. Morgan Stanley just said in a recent report (in contrarian fashion), that they're expecting a 100bp rise in the 10Y yield in the immediate term. The FED hasn't said anything about the duration of the average inflation targeting metric they're implementing, and for good reason. They're going to use rampant inflation as the scapegoat for rate hikes. A breakout in yields is imminent, and so is the demise of debt ridden (worthless) assets...
Captain_Walker
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Excellent analysis - thanks for taking the time and sharing. The Bond Markets are where reality tends to reside more often. The stock markets are where grand delusions tend to live. :) :)
Kapucha
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What is different now in comparsion to the previous cases is that current world are spreading such ideas very fast and this just can not work because market is working differently.If most of the market participants will know this and they will expect crash then this crash will not come. I think it is better to connect this with some kind of sentiment bulls vs bear ratio. I'm just saying this not to discredit You because this is awesome work. I'm just thinking laudly.
rbarnesy
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@Kapucha, I get why you say this but remember that this indicator gives a 6-24 month lead time. That leaves a lot of time for trouble to come out of nowhere. But, remember that your statement of it being different this time was the mantra 20 years ago just before the tech bubble crashed. Information is moving faster but market info has always been incredibly fast - even back before computers. I was working on the trading floor of the Montreal Stock exchange in 1987 during the October 19 crash and I can tell your that we did not need computers to know that we where going to get slammed hard at that time. Arbitrage groups had open telephone lines on all major exchanges and brokerage office in what one might call a "virtual trading room" today. Hand signals from the arbs let us know within seconds what was moving. Later on, I could tell that something big was afoot when the bond futures pits would start to get loud. Things have not really changed that much, just the methods and that we are doing it with less manpower.
T-r-X
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So we're close to a stock market crash.
I'm long TLT since yesterday.
slimp2003
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@T-r-X, I started using EDV instead of TLT. I'll see how this plays out, but etfreply shows EDV outgains TLT, however more maxDD and volatility.