Yield curves in U.S. financial markets have long served as an invaluable guide to the bond market’s prevailing assessment of the cost of money, and more important, as an effective predictor of the future performance of economic growth and financial market direction.
Over the past two years the yield curve’s signals on the U.S. and global economies have projected a dire picture. The U.S. yield curve can be a signal for the performance of metals and it can reveal the overall risk appetite.
The yield curve is a snapshot of yields on bonds of similar credit quality, ranging from maturities of as little as one month to 30 years. The shape or steepness of the yield curve can be easily determined by the difference between selected short- and long-term interest rates.
A popular measure is the difference between yields on 10- and two-year government securities, known as the 10-2 spread. Another viable measure is the difference between the U.S. Fed funds rate target and the 10-year rate.
Normally shaped yield curves appear steep or positively sloping as they reflect the time value of money that longer- term maturities command higher yields. Inverted or negatively shaped yield curves (10-2 year yield spreads less than zero) occur when short-term yields exceed long-term yields as bond traders expect lower interest rates ahead due to an economic slowdown or lower inflation.
Inverted yield curves are often a harbinger of recessions. Historically, yield curve inversions have started about 12 to 18 months before a recession, or an economic period slow enough to have forced interest rate reductions. Of the eight recessions between 1957 and 2008, only the first two recessions (1957-1958 and 1969) were not preceded by an inverted yield curve. The U.S. yield curve inversion of Q3-Q4 2006 proved a vocal success in predicting the broadening recession, which unfolded in the ensuing two years.
And what about flattening yield curves? A situation when 10-2 year yield spreads are at or near zero could signal an expansion or a slowdown depending on whether the flattening is preceded by a positive or negative spread. If the yield curve moves from steep to flat, it is brought about by an increase in the short end of the curve in anticipation of higher interest rates to the extent of catching up with long-term yields. Such a situation usually prevails during expanding economic growth and rallying equity/commodity markets. The period spanning from Q4 2005 into the first half of 2006 was the most recent example of the yield curve moving from normal to flat, reflecting (and signaling) economic and market strength in and outside the United States.
Flattening yield curves, however, could signal a slowdown on the horizon when the 10-2 year spread emerges from negative toward zero. Thus, as curve inversions shift toward flat, the short end of the curve pushes back toward the level of longer-term yields as bond traders anticipate lower interest rates by the central bank. Such a scenario unfolded in the first half of 2007, correctly signaling the recession and market slump in the United States and the rest of the world.
INVERSIONS & DECLINING METALS
Assessing the relationship between yield curves and metals, we find that the economic slowdown foreseen by each inversion of the 10-2 spread has spilled onto the price of metals. “Before the rise” (right) illustrates how the low points in the 10-2 spread in 1994, 2000 and 2005-06) have led to a decline in the price of metals and commodities.
On each occasion, the time lag ranged between 12 and 18 months — the time span required for industrial use of steel, copper and platinum to fall under the turn of the economic tide. The increasing role of speculators and investors in commodities has helped exacerbate those moves.
The 2006 inversion was the most extended in recent history and precipitated declines in gold and copper. The decline in copper during the second half of 2006 was more extended than the retreat in gold during the same time. As the global recession dealt a blow to once-booming infrastructure projects in the industrialized and developing world, investment funds were slapped with massive sell orders in copper and gold.
While much has been published on yield curve inversions and their ability to signal economic contractions and interest rate cuts, relatively little is discussed on the opposing side of these scenarios.
Since 1990, all four interest rate hike cycles were preceded by peaks in the 10-2 spread. Just as bottoming or inverted yield spreads help predict a slowdown and eventual rate cuts, peaking yield spreads could help signal accelerating growth and eventual rate hikes.
As the gap between 10- and two-year yields can no longer push higher, peaking spreads are explained by a reduction in the extent to which 10-year yields are gaining over two-year yields, which is often reflected in a faster increase in two-year yields. Rising two-year yields occur when bond traders begin anticipating interest rate increases, prompting the short end of the yield curve higher. As this emerges, rising two-year yields begin to narrow the difference between 10- and two-year yields and the preceding increase in the spread begins to lose steam — hence the peaking of the curve.
For each of the past four rate hike cycles, the duration between the peak of the 10-2 spread and the start of each rate hike were as follows:
• The February 1994 through February 1995 cycle took place 10 months after the 10-2 spread had peaked.
• The March 1997 rate hike took place 13 months after the peak of the spread.
• The June 1999 through May 2000 rate hikes started eight months after the peak.
• The June 2004 through June 2006 rate hikes started 11 months after the peak.
The peak of the 10-2 spread may not necessarily predict incoming rate hikes. But as each of the four examples illustrates, the peak of the yield spread has either occurred in the midst of a period of steady Fed funds rates (April 1993 and June 2003) or has coincided with the bottoming of the Fed funds rate — in other words, at the same time as the last rate cut (February 1996 and October 1998).
Bringing back metals into the mix, and recalling “Before the rise,” we note how each of the four peaks in the 10-2 spread preceded a rally in commodities in general, including metals by no more than two to three months. It may be a little premature to discuss interest rate hikes during the current economic climate, but figuring out the peak of the yield spread may be synonymous to pricing the bottom in short-term yields. As this pattern unfolds, speculators may start bottom picking before the price moves are intensified by commercial orders in the ensuing six to 12 months.
Today’s zero-interest rate environment may have altered the rules of inter-bank credit creation and capital formation to households and businesses. But the interaction between short- and long-term yields continues to signal players’ assessment of the balance of credit risks ahead. Only a prolonged steepening of the yield curve could still dampen the recovery in industrial metals. In the meantime, gold and silver carry a less ambiguous positive outlook thanks to central banks’ efforts to keep the price of fiat money at historic lows and the re-emerging structural downside risks of the U.S. dollar.
Ashraf Laidi is chief strategist at CMC Markets and author of “Currency Trading & Intermarket Analysis” (John Wiley & Sons). E-mail him at email@example.com or contact him via his Web site, www.AshrafLaidi.com.