Much has been discussed of late regarding the yield curve. There are those who fret over what appears to be its imminent inversion. Others tell us not to worry since the market usually has another year or more before it cares about the yield curve inversion.
So, what should investors really think about the yield curve?
There are several ways to look at the yield curve, but we'll use the 2/10 spread, which is the difference in the yield between the 10-year Treasury note and the 2-year Treasury note. The difference is currently hovering around 0.33, down from near 1.0 a year ago.
Let me preface this, though: I am not an economist nor am I a Fed watcher; I'm just an old-fashioned chart reader looking for a pattern.
I will not take you through all the previous inversions (when the spread goes negative, or dips under zero) but I will make some observations about the most recent ones in the last two decades.
What I discovered is that yes, sometimes the market does peak very close to the inversion (see early 2000) but, more often than not, it's when the spread goes back to positive that the real volatility picks up.
In 1998, we saw an inversion in the spring (box A on the chart), and the market actually rallied. But then it went right back up and over the zero line and see how the S&P 500 turned down in a hurry, with volatility picking up? It then stayed positive for another year or more.
Notice the blue arrow arrived in the first quarter of 2000. That timing was pretty darn good, in my view, as the markets did peak then. The curious thing is that the market spent a lot of time with ups and downs and did not break down until the spread went positive again (box B).
Looking at 2006, we see that we had a minor inversion right at the end of 2005 but it bounced right back and then the real inversion arrived in February 2006 (box A). See how the market went back up in March and really took off to the upside in April?
Now look at the S&P. It was merrily chopping along with some upside until May when it immediately saw downside and volatility arrived in a hurry. Again, it was the move from negative to positive that caused a spike in volatility.
The market re-inverted in the spring of 2006 (B on the chart) and stayed that way until the spring of 2007 (C on the chart). The market did not actually make its high until October 2007 but the volatility was already on the rise in the spring of 2007.
As you can tell, this is not perfect in terms of timing but I know I found it interesting that it typically wasn't the actual inversion that tipped the scales, but when rates started back down enough to turn the curve positive again.
This doesn't mean we can't or won't have volatility until the curve inverts and re-ignites but I believe we should expect a much higher level of volatility after it then turns positive.
In the meantime, I can't tell you that an inverted curve is always good for bank stocks because it isn't. All you need to do is see the banks in 2006 and 2007 to know that. What I can tell you, however, is that in the last two years, since the Fed began hiking, the Bank Index relative to the S&P has bottomed in the third quarter and has seen a fourth-quarter rally.
The red circles on this chart, above, show the 2016 and 2017 lows. The green circle is the current situation. If we are ever going to see the banks finally lift, the second half of the year would be the right timing.
Note: This material originally appeared as part of TheStreet's Online Investing Summit.