The US S&P 500 index has jumped by 64% since March 2020 despite worsening COVID-19 conditions and unemployment. The discrepancy between stock market and real economy makes more and more investors question when the stock market is going to fall.
Even though predicting future is notoriously difficult, economic research provides us with tools to peek deeper into the crystal ball. For example, a research published by the Federal Reserve Bank of New York says, “the difference between long-term and short-term interest rates (“the slope of the yield curve” or “the term spread”) has borne a consistent negative relationship with subsequent real economic activity in the United States, with a lead time of about four to six quarters.”
Translating it into English, it says that the higher the interest rate of US Treasury bills is than the interest rate of US Treasury long-term bonds, the more likely the US economy will have a recession one year from now. The relationship can quite accurately predict previous recessions one to one and half year ahead of time (see Chart 1 below, the gray bars indicate recessions).
But why? This article will help you understand this, in particular, the relations between bond, interest rate, and future stock market and economic development.
Bond and Interest Rate
Let’s start with bond. Simply put, bond is one way for institutions (e.g. government and corporations) to raise capital. But unlike stock, which represents ownership of an institution, bond represents debt. Also, return on stock investment is uncertain as it depends on company performance; whereas bond often offers fixed-return rate.
When we buy bonds (debt) from government, for example, we lend our cash to the government for a certain period of time. In return, at the end of the period (or when a bond is said to “mature”), we receive our principle back plus interest.
Bond issuers adjust interest rates (also called coupon rate) to attract investors. When numerous investors demand bonds, issuers lower interest rates because it is easy to find buyers (lenders); when there are few buyers, bond issuers would raise interest rates to sweeten the deal.
US Treasury Debts
The debts issued by the US Treasury are often considered zero-risk investment because it is extremely unlikely for the US government to default on its debts. The US Treasury issues three types of debts: long term bond (10+ years maturity), medium term notes (1-10 years maturity), and short-term bills (<1 year maturity).
Treasury Bonds and Stock Market
One way to look at financial markets is through the lens of supply and demand of assets. When demand exceeds supply, asset price goes up; vice versa. In the stock market, demand for stocks is affected by the relative profitability and risk that investors face.
Because of its low-risk nature, US Treasury debts are often used by investors to lower portfolio risk (more on this below).
Since investors are motivated to maximize returns, when stock market is expected to provide much higher return than risk-free investment, such as US treasury 10-year bonds, demands for stocks increase, pushing up stock prices; vice versa.
For example, if investors expect stock market to generate 7% annual return and the interest rate of US treasury 10-year bond is only 0.5%, then they may consider the risk in stock market reasonable for the extra 6.5% return and buy more stocks.
However, if 10-year US treasury bond has 6% annual interest rate and stock market return remains 7% per year, then investors would prefer 6% risk-free return to much riskier stock market.
So, in the financial markets, we often can observe an inverse relation between stock market and US Treasury bond market (Chart 2).
What Term Spread Can Tell Us about Future
Term spread measures the difference between interest rates of long-term bond and short-term bills (in our case, the difference between long-term Treasury bonds and short-term Treasury bills). If we apply the aforementioned supply-demand perspective to bonds and bills, then high demand those debts would result in low interest rates (and high prices) and low demand high interest rates (and low prices).
Because of this relationship, term spread can tell us what investors in the market think what will happen to the economy in the future. When investors are optimistic about stock market and future economy, they are willing to take risks to earn high returns. Consequently, (1) they put more money in stock market and buy short-term treasury bills to lower short-term risks, which drives up stock market prices and lowers interest rate for bills, and (2) the demand for long-term bonds drops, which drives up its interest rate. As result of this optimistic expectation, the term spread (long term bond interest – short term interest rate) goes up.
When investors are pessimistic about future economy, however, they flock to buy long term bonds to preserve account value (low return is better than negative return) and demand for stocks and short-term bills. Consequently, bond interest rate drops (prices go up) while short-term bill interest rate rises and stock market collapses. In this scenario, spread term decreases and could enter negative territory (see Chart 1 at the beginning).
Market Correction in 2021?
In late 2006 and early 2007, the treasury term spread reached negative points (Chart 3). One year later, the stock market went through one of the worst recessions in modern history. The next time when spread term became negative was in May 2019, pretty accurately predicting market collapse in early 2020 without knowing the COVID-19 pandemic. The most recent time of negative term spread happened in February 2020, making it nearly 31% likely for another market correction to happen in February 2021.
Although 31% may not seem very likely, it is pretty high possibility given that the negative term spread in January 2007 forecasted 38% likely for a market crash in 2008. So, investors are advised to start preparing for market correction for the least in early 2021 (acquiring low risk assets such as consumer staples sector stocks).