The yield curve is a remarkably useful leading indicator of major economic
and financial-market events. For example, its long-term trend can be relied
on to shift from flattening to steepening ahead of economic recessions and
equity bear markets. Also, usually it will remain in a flattening trend while
a monetary-inflation-fueled boom is in progress. That’s why I consider the
yield curve’s trend to be one of the true fundamental drivers of both the
stock market and the gold market. Not surprisingly, when the yield curve’s
trend is bullish for the stock market it is bearish for the gold market, and
vice versa.
A major steepening of the yield curve will have one of two causes. If the
steepening is primarily the result of rising long-term interest rates then the
root cause will be rising inflation expectations, whereas if the steepening
is primarily the result of falling short-term interest rates then the root
cause will be increasing risk aversion linked to declining confidence in the
economy and/or financial system. The latter invariably begins to occur during
the transition from boom to bust.
A major flattening of the yield curve will have the opposite causes,
meaning that it could be the result of either falling inflation expectations
or a general increase in economic confidence and the willingness to take
risk.
On a related matter, the conventional wisdom is that a steepening yield
curve is bullish for the banking system because it results in the expansion
of banks’ profit margins. While superficially correct, this ‘wisdom’ ignores
the reality that one of the two main reasons for a major steepening of the
yield curve is widespread, life-threatening problems within the banking
system. For example, the following chart shows that over the past three
decades the US yield curve experienced three major steepening trends: the
late-1980s to early-1990s, the early-2000s and 2007-2011. All three of these
trends were associated with economic recessions, while the first and third
got underway when balance-sheet problems started to appear within the banking
system and accelerated when it became apparent that most of the large banks
were effectively bankrupt.
Here’s an analogy that hopefully helps explain the relationship (under the
current monetary system) between major yield-curve trends and the
economic/financial backdrop: Saying that a steepening of the yield curve is
bullish because it eventually leads to a stronger economy and
generally-higher bank profitability is like saying that bear markets are
bullish because they eventually lead to bull markets; and saying that a
flattening of the yield curve is bearish because it eventually — after many
years — is followed by a period of severe economic weakness is like saying
that bull markets are bearish because they always precede bear markets.
Both rising inflation expectations and increasing risk aversion tend to
boost the general desire to own gold, whereas gold ownership becomes less
desirable when inflation expectations are falling or
economic/financial-system confidence is on the rise. Consequently, a
steepening yield curve is bullish for gold and a flattening yield curve is
bearish for gold.
The US yield curve’s trend has not yet reversed from flattening to
steepening, meaning that its present situation is bullish for the stock
market and bearish for the gold market. However, the yield curve is just one
of seven fundamentals that factor into my gold model and one of five
fundamentals that factor into my stock market model.
