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PREDICTING STOCK

MARKET TURNING
POINTS
The most reliable indicator to forecast a
recession

Stock Market & Yield Curve


It is causality
In 2000 and 2007 the yield curve became inverted. This is not correlation

this is causality as we will see later

Yield Curve (10y-3m)


5.00

S&P 500
2500

4.00

2000

3.00
1500
2.00
1000
1.00
500

0.00

-1.00

Inverted Yield
Curve

Yield Curves
Normal vs. Inverted Yield
Curve
Central banks consider the yield curve as a powerful indicator with
regard to the state of the economy.
An inverted yield curve can tell you a lot about the conditions in the
credit market and what may happen in the bond/stock market and
the economy.

Normal Yield Curve


r

Inverted Yield Curve


r

Short term rates are


higher than long term
rates

Long term rates are


higher than short term
rates
t
r = level of interest rates; t = time

An inverted yield curve is bad news for the economy


When you are leveraged you have a
problem

An inverted yield
curve is bad for
borrowers who
rely on short
term financing or
have credit
contracts with a
variable rate

Businesses get hurt because


they finance their operations
usually short term (inventory,
wages etc.)

Consumers get also hurt when


their variable rate is reset at
higher rate (i.e. ARMs)

And especially highly leveraged


financial institutions get in
trouble because they finance
their portfolios short term in
order to maximize their profits

A banks balance sheet in a normal interest environment (normal


yield curve)
Everthing is fine

Assets

Liabilities

The spread 300 bp. is the profit forDeposits:


the bank.
2%Short term interest
rates (3%) are below long term interest rates (5%)
Banks lend
money @ 5%

Banks borrow
money @ 2%

Loan: 5%
Money
market: 2%

A banks balance sheet when the yield curve is inverted


Now we have a
problem

Assets

Liabilities

The spread is negative -100 bp.


Deposits:
Without new borrowers who borrow
money 6%
above 6% the banks
profit is negative
Banks lend
money @ 5%

Banks borrow
money @ 6%

Loan: 5%
Money
market: 6%

This is how and why it happens (I of II)


Central Banks are
important
Short term interest rates are strong influenced by the actions of central

banks.
Central banks usually raise interest rates to fight inflation. So when

central banks tighten the money supply via interest rate hikes short term
financing becomes more expensive and therefore unattractive.
As a result consumer and business have to spend more of their income

to debt service payments.


Potential new borrowers get discouraged and banks become more

reluctant lend to consumers, business and other banks.


Highly leveraged banks get squeezed and are forced to sell assets or

terminate long term contracts - if possible.

This is how and why it happens (II of II)


The process in self-enforcing

Borrowers who are not able to service their debt with their
income are forced to sell their assets. This has a negative
effect on the respective asset market since more supply
means falling asset prices
The process in self-enforcing because less spending means
less income
Falling asset prices reduce borrowers ability to get credit
because his/hers collateral (asset) is falling in price
When the leverage (debt) in a specific asset class (i.e. real
estate) is at high levels a recession is almost inevitable

The current situation


Remember the Great
Depression?
Currently interest rate in the US and the Eurozone are at zero
The last time that this happened in the US was during the Great
Depression, i.e. about 80 years ago
So do not expect to see an inverted yield curve the next time the
stock market goes down
What happens in the bond/stock market depends heavily on the
actions of central banks and not so much on the economy, i.e. QE
etc.
Stock markets at record highs accompanied with low inflation and
growth below potential make only sense when you see it in the
context of the actions of the central banks
Central banks playing for time to fix the underlying problem let's
hope they succeed

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