Prelude To A Bull: The Economic Signs That Signal Market
Bottoms, Part I
By Tony Crescenzi

The bond market has a crystal ball that the equity market should take a look at:
the yield curve. The events of this past year have once again proven the value of
using the yield curve as a predictor of future economic and financial events.

For investors that heeded the warnings inherent in the yield curve at the start of
last year, they are now sitting on a pot of gold. For everyone else, well, they are
looking at their stocks like a deer at headlights.

A Yield Curve Primer
Before I go on, let me give you a little primer on the yield curve. For simplicity’s
sake, assume that when I say “yield curve” that I am talking about the yield curve
for U.S. Treasuries.

The yield curve is basically a chart that plots the yields on bonds carrying
different maturities usually ranging from 3 months to 30 years.

When bond investors analyze the yield curve to try to glean its meaning, they
look at the difference between yields on short-term securities compared to that of
long-term securities. The spread between the 2-year note and 30-year bonds is
commonly used. A “normal” yield curve is one in which long-term maturities have
higher yields than short-term maturities. In such a case, the yield curve is
deemed to have a positive slope. The curve is considered inverted when long-
term maturities have a lower yield than short-term ones.

The shape of the yield curve can mean a variety of things to bond investors but

First of all, the inversion was occurring because the bond market was beginning
to believe that the Fed would have to raise rates aggressively to slow the
economy. That’s exactly what happened; the Fed raised rates one full
percentage point over the next four months. In turn, bond investors began to
believe that economic growth would decelerate.

It did.

Stock investors took time to heed the yield curve’s message that the Fed would
put its chokehold on the economy but it didn’t take all that long. It is probably no
coincidence that the Dow Jones Industrial Average peaked the same month the
yield curve inverted. The S&P 500 and the Nasdaq peaked just a couple of
months later in March.

The Current SituationSo what is this crystal ball telling us now?

For starters, note that the yield curve became positively sloped for the first time in
almost a year on December 9, 2000. The return to a positive slope has a few
implications for the markets and the economy. First and foremost it indicates that
the markets expect the Fed to be friendlier toward the markets. Indeed, the Fed
has already turned friendly toward the markets having announced a surprise rate
cut on January 3. Moreover, the bond market is priced for nearly 150 basis
points of additional rate cuts this year.

Second, as a result of the expectation for future Fed rate cuts, the bond market
believes the economy will regain its footing again after a period of weakening.
This view is reinforced by the notion that the Bush administration will be