An early warning signal for a bear market

One of most reliable early warning indicators of an impending equity bear market is the shape of the US yield curve. When short-term interest rates are higher than long bond yields, it is a sign that monetary policy is tight enough to choke off growth in the economy and company profits.

The measure of the US yield curve we have used in the first chart is the spread between the US 10-year Treasury yield (2.58% at the time of writing) and the US 2-year Treasury yield (1.36%). The difference of +1.22% can be seen on the right-hand scale. Overlaid with the yield curve back to 1980 is a chart of the US S&P 500 index shown on a logarithmic scale.

When the yield curve spread drops below zero, indicating very tight monetary policy, it is a clear warning sign that equity markets (not just in the US but globally) are vulnerable to a significant sell-off. Economic recessions have sometimes followed, with plunging share markets heralding their onset. The dot-com crash of 2001 and the Global Financial Crisis of 2008 were both preceded by inverted yield curves in the US.

The US yield curve remains positively sloped, but the spreads have narrowed from over 2.50% to 1.22% now. We are not close to yield curve inversion yet and may not be for some time. However, with the equity risk premium down to just 3.0% and the Fed likely to continue tightening monetary policy this year, it is worth keeping an eye on the yield curve as an early warning indicator.

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