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Yield Curve Is Steepest Ever

On Monday, the headlines on financial sites were screaming that the yield curve (specifically the spread between the two-year and the 10-year Treasury notes) had reached its highest level ever at 282 basis points. How should you react to this news?

If you read the articles, the implication is that this is good news because the yield curve is a barometer of future economic activity. And there's academic research that demonstrates this is the case -- the difference between long-term and short-term interest rates 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.

So perhaps this is the "all-clear" signal investors have been waiting for before they jump back into the market. Despite the great rally the equity markets have experienced since March, equity mutual funds have actually experienced net outflows this year. On the other hand, taxable bond funds attracted more than $250 billion and municipal bond funds about $60 billion.

However, there's a major problem with this line of thinking. The stock market itself is a leading indicator of the economy. In fact, it's one of the 10 components of the government's index of leading indicators.

Thus, while the yield curve may have predictive powers in terms of economic activity, it has no value in terms of investment strategy. This year was the perfect example, with the stock market recovering before the economy did.

Here's one more bit of evidence to consider. Prior to the recent bear market, the S&P 500 Index had returned more than 16 percent per year (about 60 percent above its long-term average) when the Consumer Confidence Index had been below 55 over the prior 40 years. Note the index bottomed out in January at 37.7, not long before we began the greatest bull market since the Great Depression.

The lesson for investors is that if you wait until the all-clear signal arrives, it's likely that you'll miss out on much of the returns earned by those that have the patience and discipline to stick to their investment plan.