## Wednesday, May 7, 2008

### US Yield Curve

The yield curve is simply a ratio that is derived by dividing a long term yield with a short term yield.

For example, the yield for the US Treasury 3 month bill closed at 1.62 and the yield for the US Treasury 30 year bond closed at 4.66 on Tuesday. Therefore the value for the yield curve is 2.88 (4.66 divide by 1.62).

The steepness of the yield curve can be used to predict the performance of the stock market. This is because when the yield curve is steep, banks earn money by borrowing short term and to loan long term. The reverse happens when the yield curve is inverted or flat. Hence when the yield curve is steep, banks have every incentive to loan out as much as possible and to borrow to the limit of their reserves. And when that happens, there will be excess liquidity to drive up the stock market.

I have done a study by using the data from Yahoo (Symbol: ^TYX - 30 year bond and ^IRX - 13 week Treasury bill).

Enter
1. Compute the Ratio = (^TYX)/(^IRX)
2. If ratio crosses value of 1.15, enter a long position

Exit
1. Closed the long position after 12 months.

The trading result is as follows:
Entry DateEntry PriceExit DateExit Price% ChangeDraw Down %Max Gain %Bars Held
6/2/1980850.856/1/1981991.7516.56-1.192921.170612
12/1/1981888.9812/1/19821039.2816.91-13.386121.314312
6/1/1982819.546/1/19831199.9846.42-6.047351.852312
8/2/1982808.608/1/19831199.2248.31-4.776255.913912
5/1/19902656.765/1/19912887.878.7-11.760614.065612
9/4/19902614.369/3/19913043.6016.42-10.329517.376712
2/2/19987987.462/1/19999405.4317.75-7.608922.184512
4/1/19988818.504/1/19999825.2911.42-16.315715.196112
8/3/19988868.108/2/199910654.8320.15-16.783727.666712
10/1/19987749.4210/1/199910335.6933.37-4.511847.481212
1/4/19999212.841/3/200011501.8524.85-2.372626.548212
4/2/20019877.164/1/200210402.075.31-19.744815.786512
9/4/200713358.39OpenOpen-2.91-13.84646.89889

The trading result is not exactly spectacular but it is definitely better than return from fixed deposits.