There are a number of indicators that traders look for as an early signal to denote a potential stock market crash. The Hindenburg Omen, the McClellan Oscillator and the Bond Yield Curve. Today I will cover the bond yield curve and how it can signal a potential stock market crash.
Government bonds are purchased by investors as a long term, sure-fire return on investment. Unless you are Argentina who are the only developed country to have defaulted on government bonds, then they are a solid investment. When the return ‘(the yield’) on long term bonds decline, this can be seen as a faltering economy.
The yield curve shows the slope shaped by the yields of government bonds of various maturity dates. (2 years, 5 years, 10 years etc). It costs more to issue long-term bonds than shorter term ones, as the interest rates paid to the inerstor are higher, as they are investing their money for a longer term. Typically the curve will slope upwards, commonly depicting a healthy economy.
If investors are confident inflation is seen to be making steady progress looking further into the future, along with gradual interest rate increases (say over 5- 10 years), then the 10 year bond yield will be higher compared to the shorter term, 2 Year bonds. Investors in longer term bonds will receive higher interest payments compared to 2 year bonds.
If inflation expectations drop due to a slowing economy, then the yield on the longer term ten year bond will fall, and the difference (‘the spread’) between this and the 2 year bond will decrease. This would be seen as a flatter yield curve. A flatter yield curve is a sign of a weakening economy.
Yield Curve Graph
The graph below shows a typical yield curve sloping upwards. Comparing the yield curve from just a year ago, you can see that the 30 year bond yield has decreased causing a flattening of the curve. To put this into some context, a flattening bond yield curve and a rising stock market is an example of divergence and these signals should be monitored carefully to alert an early signal as they reach there extremities.