By Michael Krewson
What if I told you that one indicator has predicted every US stock market crash since the great crash of 1929?
The most commonly used market crash indicator among traders I know comes from the interest rates of government-issued bonds. To try to make everyone else feel like we earn our money, we use a fancy term: The Inverted Yield Curve.
What does that mean? The US government issues bonds called Treasuries. With some of them the government doesn’t have to pay you back for a long time, say 10 or 30 years. With others the government has to pay you back in a relatively short period of time, say 1 or 2 years.
Ordinarily, if the government gets to keep my money for a longer period of time then I want to get paid more for it, right? But occasionally, the opposite happens. And this is such a shocking scenario that we really did feel like it warranted a fancy name.
Okay, you’re asking me. Why on Earth would smart finance guys who are in charge of billions of dollars be willing to get less for more?
Here’s one interpretation: Sometimes, the market tells us that investments will do a lot better over the long term than they will over the short term. Maybe you want any guaranteed return you can get for the short term, and once the market shakes out you’ll be more comfortable investing for the long term again. That is, things may not go so well in the next couple of years.
There are plenty of technical questions to ask. Will it always work? (No.) Which issues do we choose? (Commonly the 30-day, 2-yr, and 10-yr.) But first let’s watch the magic.
On these charts, whenever the longer-term bonds start paying less than the shorter-term bonds — that is, whenever the “spread” dips below zero — recession (areas shaded gray) may be just around the corner. So if the yield curve inverts, look out!
10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity
10-Year Treasury Constant Maturity Minus Federal Funds Rate
I didn’t have a non-proprietary chart going all the way back, apologies. The second chart illustrates the effects of using a different short-term rate. There was a big market crash in 1987, but no recession. Source