The Yield Curve suggests that the US stock market is Fairly Valued

 SOURCE:

Yield Curve Valuation Model (currentmarketvaluation.com)

Overview

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The US Treasury Yield Curve is quickly flattening, meaning short term interest rates are moving up, closer to (or higher than) long term rates. 

This unusual occurrence has historically been a very reliable indicator of an upcoming recession. Since World War II every yield curve inversion has been followed by a recession in the following 6-18 months, and recessions are naturally correlated with decreased stock market returns. 

The below chart shows our model, tracking the spread between the 10-Year to 3-Month US Treasury Yield Curve. The last inverted curve of 2019/2020 did in fact precede the subsequent April 2020 recession.

While our 3mo/10year model still shows reasonably normal performance, short term yields are quickly moving up, and portions of the yield curve are now beginning to flatten and even invert.

Overview

Theory

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The yield curve refers to the chart of current pricing on US Treasury Debt instruments, by maturity. The US Treasury currently issues debt in maturities of 1, 2, 3, and 6 months -- and 1, 2, 3, 5, 7, 10, 20, and 30 years. These are bonds just like any other - meaning that if you bought $1,000 of the 10-year bonds with an interest rate of 2%, then you would pay $1,000 today, then receive $20 at the end of years 1-9, and receive $1,020 (representing $20 interest + your original $1,000) at the end of year 10. Current interest rates are shown on the US Treasury's website.

The interest rates that these bonds pay reflect two main factors: 1) the Federal Funds rate, and 2) expectations of future returns.

The Federal Funds Rate

The Federal Feds rate (aka the fed funds rate) is the target rate set by the US Federal Reserve and is the interest rate that banks use to lend/borrow from the Federal Reserve overnight. This is almost always the "interest rate" you hear about on the news when there are headlines about rates rising or falling, and this rate sets the foundation of almost all other economic interest rates. Since the fed funds rate is the rate at which you can effectively lend cash to the US Government overnight, this rate serves as the foundation of the yield curve - it is essentially a US Treasury bond with a 1-day maturity. When the Federal Reserve changes this rate, all other rates tend to change accordingly as well.

Figure 1

Expectations of Future Returns

The Federal Reserve sets the overnight interest rate - but the interest rates on Treasury bonds from 1-month to 30-years are set by the market and fluctuate with investor demand. For example, assume that the Fed Funds rate is 2%. This indicates that investors can lend money to the US Government overnight and receive a 2% annualized rate of return. If that is true, then we would generally assume a 1-month Treasury bond rate to be a little higher than 2%. This is because investors value optionality. They like having access to their money in case something better comes along, so they require extra return if they're going to lock up their money for a full month - otherwise instead of buying a 1-month bond, they would just buy the overnight bond every night for a month.

To better illustrate this - assume that the 3-month Treasury bond rate is 2.5%. Again, this says that an investor can lend their money to the US Government for three months and receive 2.5% annualized interest in return. If you are the investor, what rate would you need to receive in order to extend this loan to the US Government from three months to ten years? Ten years is a long time, and many more attractive investment opportunities may come up. If you've committed your money to a US Treasury bond and won't get it back for ten years, you need to be getting paid enough for it to be comfortable that nothing substantially more attractive is going to come along in the meantime. Otherwise, why not just keep investing in the three month bond every three months?

Accordingly, it is almost always the case that as the maturity period increases, the interest rate on Treasury bonds increases as well. This is called a normal yield curve, and is illustrated in the rates below, from Jan 2017.

Figure 2

Inversion

Yield inversion is the term used when long term rates are lower than short term rates. This happens when investors are nervous about the future and expect short term rates to fall. When so many investors think rates are going to fall, they will crowd into the longer-dated bonds to try to lock in the 'high' rate for as long as possible.

For example, assume that the economy is roaring, and the Fed Funds rate is 4%, 3-month rate is 4.5%, and the 10-year rate is 6%. This would be quite normal, as described and illustrated above. Now assume that you are an investor who thinks that the economy is weakening, and likely to slow down in the near future. If this were to happen, you would predict that the Federal Reserve would need to lower short term interest rates in order to juice the economy a bit (i.e., basic monetary policy). If this were true, and you expected all rates to go down in the near future, you would invest more in long-term bonds (10, 20, 30-year), in order to 'lock in' those good rates. When many investors begin to do this, the rates of long term bonds fall, and may actually fall below the rate of short term bonds.

Inverted yield curves are very rare - occurring only once a decade or so, and almost always immediately before a recession.