There’s a lot of talk about the possibility of a crash in the stock market and another recession starting. Going into the final days of an election in the US (won’t all of us be glad when that is over!) there is no shortage of commentators who want to point out the economic perils of either candidate.

Condition 1 – Let’s go crazy!

The first condition for a crash is a reaction to “mania” in the market. You know—the kind of mania when you’re getting stock tips from your cab driver. When TV programmers pump out popular TV shows on real estate and investing. When bookstores are full of books on investing, and the talk around the lunchroom is about people who struck it rich in the markets…

Condition 2 – Show me the money!

The second criterion for a crash is a loosening of credit requirements. Remember the 110% mortgages and low-doc loans? In the four years that I have been in the US, I’ve witnessed a dormant construction industry spring back to life with new projects springing up everywhere. The difference, compared to 2005-2007, is that the new projects are constrained by tight credit requirements (they all have to be well-funded). It is inevitable as time goes by that the restrictions will be loosened (I just saw Alan Greenspan on Bloomberg TV advocating the repeal of the Dodd-Frank restrictions on banks – watch for a lot more of that). Again, we are not back to the days of the NINJA loan right now (No Income, No Job and No Assets).

Condition 3 – Time to yield the results!

This is the easiest for us to see by looking at the Yield Curves. We do this by taking multiple related datasets and combining them on a single chart. By reviewing the values, we can easily see when there’s a change in the relationship.

With the Yield curve, we can compare what the Governments are paying in interest (Fixed Income) on investments from 1 Month Notes to 30 Year Bonds. Of course it’s not enough as an analyst to only look at the curve today, we need to go back in history and see if we can pick up any clues. We’re recession hunting after all. For that we need a 3D chart.

It can be hard to view in a simple image, so I’ll explain what we are looking at. Along the bottom axis (rising to the right), we have each of the US Government Yields from 1-Month through to 30-Year. You can see their names along that edge, starting with USGG1M INDEX (Bloomberg Data). The vertical axis is the percentage Yield, and the other horizontal axis (rising to the left) is our time axis. The mini 2D Chart in the bottom corner shows the snapshot of the last date in our range.

In this chart we are looking at April 30, 2004. We can see a smooth rising Yield Curve. This is what we would call “normal” and means that an investor will get paid a higher yield for a longer-term investment. This is what you would expect. You would want a higher annual return from a 30-year investment to compensate for the longer exposure to risk.

NOTE: Remember that all Yields are annualized. So the 1-Month Yield is the annual rate of return.

When confidence is high and credit is cheap, the markets begin to overheat. Consumers are buying all sorts of wonderful goods and services and companies expand to meet the new demand. They employ more people, sending wages higher, which increases the demand for products.

When it starts to get out of control, and there is a risk of hyperinflation, the Reserve Banks step in to increase rates. By increasing the costs of credit, suddenly that expansion project is no longer viable and gets put on hold. That new extension on the house will cost a bit too much, and that new car is not so shiny any more. Employees start to lose their jobs and the economy slows. The effect on the economy is not instant, it takes a few months to react. That is great as we can get advance warning of what is coming. The first place we see this reflected is in the short-term rates. 

In this chart we’ve moved our Yield Curve to Mar 27, 2007.

You can see here that the short-term Yields were higher than the long-term. The brakes are on at this point.

To understand why this matters, we need to think about it from the point of view of an investor who is looking for the best (and safest) returns. If I can get the same return from a short-term Note or Bill which is backed by the Government, why would I buy shares and take the extra risk of capital depreciation? Even if it does pay a slightly higher dividend, I still value safety of moderate returns with no risk (well… low risk). If the market has been up for a long time, history would also tell me that there’s a likelihood of a correction coming. You can bet that the Portfolio Managers of the world’s largest funds are thinking the same thing, and there will be a migration of funds out of Equities into Fixed Income.

In the example above the curve looks mostly flat and only slightly inverted. However, because of the risk exposure, this is a huge issue even when it is flat. The risk on any Government Bond is relatively low, there is still a risk that a policy change or a default can happen and wipe out my investment. If I can get the same return on shorter duration investments, I’ll take it so I can cycle my money faster.

As credit costs go up and the economy slows down, projects are put on hold and the goods and services provided by companies are no longer needed. Their profits fall which means their dividends fall, and the safe returns of the government yields look even better. This is the perfect storm for equities and is what causes the crashes in the market. As the price goes down, the yields are looking better and better.

Nearly all the major recessions—and most of the crashes—have been preceded by an inverted or flat yield curve. From a definitional point of view, the raising of rates is likely to lead to a crash (or a significant Bear market) as funds move into Fixed Income. That then has a knock-on effect on the whole economy and leads us to recession.

So the question is, where are we right now?

You can see that we currently have a very healthy looking yield curve in the US.

Following is the curve for Australia.

Again, it’s a very healthy looking curve.

Finally, for a long-term view I have used the Five Year and Thirty Year from our EOD data sets. In the bottom pane, I have subtracted the 5 Year from the 30 Year to highlight periods when the curve was inverted. When it is Green, the 30 Year is greater than the 5 Year and all is good. When it is red, it is inverted. The line getting to zero is when we are flat (still not good). All of that is put on a Logarithmic Chart of the S&P 500 with recessions highlighted.

What we see is that historically, recessions in the US (Green Zones) are preceded by inverted or flat yield curves.

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