Yield inversion – a good predictor of the next meltdown?

Yield inversion occurs when long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality. This is considered to be a predictor of economic recession. Historically, as shown in the graph below, it appears that in instances when the yield on 10Y US Treasury fell below that of 2Y US Treasury, a major crash in the equity market will happen next.

YieldInversion-Curve 30092018.png

When is the expected date for the first yield inversion?

Based on simple extrapolation forecast method in Excel, it is anticipated that yield curve is expected to be inverted by early November 2018 (this coincides with the next FOMC meeting on 7-8th November 2018). Nevertheless, based on 95%-confidence interval, we may also see the possibility of yield curve inverting as early as 1st-2nd week of October 2018.

YieldInversion-Forecast.png

When should we expect the major crash to happen?

07af886e750a926f19258533defa560f.jpg

Let’s study on what we can infer from past yield inversion occurrence:

As shown in the table below (based on three past yield inversion occurrence):

  • From the first date of inversion, the stock market may continue to climb for another 581 – 651 calendar days, averaging at 610 days
  • Average percentage drop (from highest point to lowest point) is approximately 38%

Yield History.png

Assuming the first date of yield inversion materialises on 5th November 2018, we may be potentially witness a major stock market crash happening in between Jun-Aug 2020.

What else can we look for (i.e other indicators)?

The above desktop analysis is based on very simple assumptions / analysis. Personally, I will look at other indicators to jointly assess the possible timing of the next meltdown.

ISM

Will watch out if it falls below 50. Currently, it is above 50.

ISM.png

Unemployment rate

As shown in the graph below, once unemployment rate does not drop further, this may be considered indication of a possible recession / stock market crash  . Currently, the US unemployment rate is at historical low, something to watch out in the next 1-2 years.

Unemployment Rate Sep 18.png

Schiller PE / Wilshire GDP

Schiller PE is currently at historical high (excl. tech bubble in 2000). High possibility of market reversal.

schiller PE.png

Wilshire Total Market Cap to GDP is at all-time high. High possibility of market reversal.

wilshire.png

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