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The steepness of the U.S. yield curve has a successful track record for predicting recessions, so the recent flattening of the curve has caused considerable handwringing among economists.

In the past, the yield curve has also provided investors with an early warning system for major equity market sell-offs. More recently, however, there are signs that the aggressive monetary policy of former Fed Chairman Ben Bernanke has broken the link between bond markets and future S&P 500 performance.

The long-term trend has been for the steepness of the yield curve – measured by the 10-year U.S. Treasury bond yield minus the two-year bond yield – to forecast market activity 24 months later. The lag between changes in the yield curve and their effects on equity markets is attributed to the banking sector. A steeper curve makes lending more profitable, and the effects of changes in lending activity take two years to become apparent in equity prices, according to this school of thought.

The chart below shows the steepness of the yield curve plotted against the forward two year cumulative return on the S&P 500. (For example, the first data point on the blue line is 74 per cent, labeled April 19, 1996. It shows that between that date and April 1998, the S&P 500 climbed 74 per cent).

From April of 2000 to the end of 2008, the yield curve provided terrific guidance for equity investors. The curve steepened strongly from March 2000 to July 2003, and this successfully predicted a strong equity market two years later. The same process worked in reverse – flattening curve and an eventual downward slide in equity prices – from 2003 until 2007. The curve steepened in the 2007 to 2008 period, and markets eventually followed suit in recovery from the financial crisis.

Things break down after that – the curve is little help for investors looking for hints on future equity market performance – and I suspect the Federal Reserve is why. Before the crisis, short-term interest rates roughly reflected the economic growth environment. Post-crisis, in an effort to stimulate growth (and protect the banking system from further loses), the Fed kept short-term rates lower than economic conditions warranted. This made the yield curve artificially steep, and provided false signals for equity investors.

Current Federal Reserve chairwoman Janet Yellen uses the term 'normalization' to describe the central bank's intentions to raise interest rates to levels reflecting the economy. It's possible, and maybe probably, that normalization will result in the yield curve regaining its ability to predict equity markets.

Follow Scott Barlow on Twitter @SBarlow_ROB.

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