Yield Curve Analysis Along the Economic Cycles July 2010

Yield Curve and the Economic Cycles

March 2003: Steep Yield Curve – Bond market expects high growth and inflation, thus selling the long end and
loading on the short end. This is good signal for underweighting bonds in the portfolio and overweighting stocks
that will benefit from the future economic growth.

May 2005: Signs of Flattening in the mid section of the Curve – The first indications of a possible slowdown in
the business cycle. Stock Bull market is entering a grinding range bound phase with upward bias.

June 2006: Flat Yield Curve – That is the original harbinger of impending economic slump. Short end of the
curve is sold by the bond vigilantes as they demand higher yield. The Flat Yield Curve signals that market is
weighting much higher the risks of ending the economic growth phase. This means we must underweight stocks in
the portfolio and buy bonds to position for the bear stock market.

Kiril L. Yordanov kyordanov@gmail.com

1 http://constellation1976.blogspot.com/
Yield Curve Analysis Along the Economic Cycles July 2010

March 2007: Inverted Yield Curve – This is the ultimate sign of the end of the Secular Bull market in stocks. It
became known in hindsight that John Paulson of Paulson & Co. started shorting the CDO tranches in the mid 2007.
Inverted Yield Curve points out that inflation is putting a lot of pressure and investors are chasing higher return in
the short term. That coincides with the terminal phase of the Bull stock market. That is last call for getting out of
Equities and parking funds into the short end of the Yield Curve which is incredibly paying higher than the long
end. This is exactly the paradox that tells us that something irrational is going on in the market.

August 2007: Volatility expansion in the Short end of the Yield Curve – The increase in Volatility is always
symptomatic to the start of the Distribution phase of the market dynamics. Suddenly yield-hungry investors start
running for cover in the so called “flight to quality” loading onto the short end and depressing the yield. With the
benefit of hindsight we can observe that after the steep appreciation in 2003 market had 2.5 years of rather steady
growth which in mid 2006 started to accelerate. Stock market here retreated from its all time high. The increase in
volatility and the fear reflected in the bond market should signal that we exit all equity holdings and go 50% cash
and 50% long bonds in the 10 to 30-year segment of the curve.

October 2007: Flat Yield Curve – Stock market makes a Double Top formation which failure signals a reversal in
the dominant trend. However the Flat curve is still telling the story of yield-hungry investors who think economy is
alright and the good times will roll forever. Prudent investors are using the second spike to liquidate equity
holdings and park money in the long end of the curve.

Kiril L. Yordanov kyordanov@gmail.com

2 http://constellation1976.blogspot.com/
Yield Curve Analysis Along the Economic Cycles July 2010

February 2008: Flight to quality depresses the Short end of the Yield Curve – Suddenly investors realize that
Bull markets don’t last forever. The chart clearly indicates how buying in the short end pushes down the short end
yields. We noticed the first signs for irrationality in June 2006 when 3m to 2-year yields were in the 5% region.
Here there are falling below 2%. The secular Bull market has ended. However the “Official” Bear market was
publicly proclaimed only in the second part of 2008 when S&P breached the 1280 lows.

October 2008: Zero Interest Rate Policy (ZIRP) - Short end is anchored at 0% - The emergency rate cuts
orchestrated by the FED and implemented on global scaled by the major CBs aim to unfreeze the global credit
market. This is the start of the deflationary environment. Cash is king. We should still hang on to the 50% cash /
50% long end bonds allocation which suits best the deflationary pressure on the economy.

December 2008: Long end Yields fall under pressure – Fear in the Bear market is feeding a rush to bonds as
investors start to worry not about the return ON the money but about the return OF their money. Investment
management is all about the Variant Perception as Michael Steinhardt had put it. While in the Bull Market prices
overvalued when measured by the P/E ratios, they become undervalued in Bear markets. The reason for the 50%
cash allocation is to buy stocks when they become oversold and Bear Market hits bottom and reverses.

Kiril L. Yordanov kyordanov@gmail.com

3 http://constellation1976.blogspot.com/
Yield Curve Analysis Along the Economic Cycles July 2010

March 2009: Yield Curve Steepens but is a bit humped – The psychological factor at the bottom is critical as
market reverses when sentiment is extreme and all hope is abandoned. I still remember 3 weeks on Bloomberg they
were asking if this last surge in stock market in March ’09 was real and nobody really believed. There is a good
system of buying undervalued equities at extreme distance to the 200-Day moving average as was the case in
March 2009. When we have a Steep Yield Curve, extreme Bearish sentiment and extreme oversold technical
reading we should gradually move into stocks with tight risk management. Bear market rallies are violent because
of the short covering and the higher risk of shorting in the public perception. The extreme measures for
orchestrated effort to re-inflate the global economy and open up the credit markets should be used as a signal to
move into equities.

June 2009: Normalized Yield Curve but still anchored at 0% - FED’s commitment to hold the interest rates for
a prolonged period of time starts to penalize the hoarding of cash. Fund managers are pressured by the dismal
performance and the losses from 2008 and they are forced to move out of money markets and into stocks. It is a
Bear market rally until proven otherwise and most of the Street and Academic authorities ranging from Faber and
Taleb to Krugman and Roubini are calling for new lows but the ZIRP is pumping cash into the system and they
need allocation.

June 2010: Normal Yield Curve + ZIRP unchanged – The normalized Yield Curve should support the idea of a
sustained economic recovery. Technically S&P is making lower lows along with rise in Volatility measured by
VIX which favors caution. I assume it is better underweight equities and move into cash as bond market has been
trending up for a few months I would expect rates to move higher sooner than later.

Kiril L. Yordanov kyordanov@gmail.com

4 http://constellation1976.blogspot.com/