Three Lessons from Janet Yellen

Watching the yield curve steadily flatten over the last couple years, I'm reminded of the classic relationship between the shape of the yield curve and recessionary periods.

However, Janet Yellen is here to say those fatal words, "This time is different."

In her late December press conference, Yellen speculated that the odds of recession are very low, due to monetary policy now versus previous cycles.

Here are three lessons I learned from the article on Yellen's comments.

1) This article needs a better visual aid.  Here's what I'm reading about the yield curve over time...

  • From two years to 10 years: 57 basis points, down from 125
  • From two years to 30 years: 95 basis points, down from 187
  • From five years to 10 years: 24 basis points, down from 52
  • From five years to 30 years: 62 basis points, down from 114

...but this is what I really need to see to understand the change in the shape of the curve.

Here is a chart of the S&P 500 index over time (top panel) with the spread between the 2-year and 10-year Treasury notes (bottom panel).  When the green line is trending up, that's a steepening curve; when the green line goes down, the curve is flattening as the spread narrows between twos and tens.

I can see the timing of an inverted yield curve (green boxes) and subsequent recessionary periods (red boxes).  I also get a very clear sense of the steepening/flattening of the curve over time by just watching the inflection points in the 2s-10s spread.

2) There certainly seems to be a relationship between an inverted yield curve and recessionary periods.  As the article states, "Treasury yields has (sic) dropped below zero ahead of each of the past seven recessions."

Yellen's comments highlight a challenge we face with any sort of long-term analysis of the financial markets.  We just don't have a lot of data to work with!  If you're looking for times when the two-year yield was higher than the ten-year yield, there have been only three observations since 1984.  

What if we limit it to observations during a secular bull market?  We now have only one observation since 1984.  As any statistician will tell you, comparing one observation to another observation and attempting to draw any meaningful conclusion is essentially statistical suicide.

Correlation is not causation.
— Janet Yellen

So why even make the comparisons? 

I've learned that it's helpful to at least have some sort of context as to what has happened in the past.  While we may not have a 100% repeat of what happened before, it can be valuable to see how different stocks/sectors/assets behaved during those periods. 

Just like reading a history book, past performance can show us how people reacted to a myriad of inputs.  And while subsequent events may be slightly different, human nature is constant.

3) Yellen made a point of saying, "Correlation is not causation."  That is, just because there's been an inverted yield curve before every recession doesn't mean that the inverted yield curve caused the recessions.

Fair point.

I would also point out the danger in taking any two variables and drawing a cause-effect relationship, as you're assuming those variables occur in a vacuum.  The financial markets are a complex system, meaning there are many different variables that can affect asset prices on any given day.

In his book The Socionomic Theory of Finance, Robert Prechter has this to say about experts touting exogenous causes for changes in stock prices.

Their explanations seem to make sense, because most people's minds resort to the mechanical notion of action and reaction when analyzing financial and social events.  When we take the time to examine the results of applying that causal view, however, we find it useless for consistently explaining market behavior.

When we look at charts, we're truly analyzing the "effect" on its own.  The "cause" of a market move is something that can be debated endlessly, and often is unknown long after the move has actually occurred.

But the one thing that is indisputable is price.  Price is driven by supply and demand and represents where a large group of investors agree on what something is worth at any given moment.

Charts like the one above aren't the dessert, they're the appetizer.  To put another way, the chart isn't meant to summarize everything you need to know about the yield curve and the stock market.  The chart is designed to be a launching pad for a discussion on market history and a debate on potential future outcomes.


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