Keystone's 2-10 Spread Indicator

The new darling of traders over the last few days is the financials. Each pundit that has a microphone or pen in front of them tells the herd to now jump into financials since they will lead the way higher for the stock market. Who knows, maybe they end up being correct, but Keystone does not agree. The thinking by the herd is that the up in rates (note the drastic jump in the 10-year yield after the jobs report resulting in a spike from 2.61% to 2.72% in a heartbeat and now a touch above 2.75%) is attractive for the banks and financials since the steepening yield curve will make it easy to make money. They are correct in this aspect but Keystone uses a 255 spread as the signal line. The higher yields result in the interest-rate sensitive stocks such as utilities, telecom and home builders selling off while banks run higher salivating over a steeper yield curve. The 2-year Treasury note yield is 0.32% and the 10-year note yield is 2.75% resulting in a 243-point 2-10 yield spread. The spread is increasing causing the investment houses and bankers to order up cases of champagne and wine in preparation for happy times ahead, however, the spread remains 12 points shy of Keystone's 255 signal line that would confirm banker nirvana; we are not there yet. As long as the spread remains sub 255, the banksters better keep the corks in the bottles.

At the market bottom in March-April 2009, the 2-10 spread was about 200 signaling the ongoing turmoil. In December 2009, the spread was up to 288 with drunken bankers toasting Chairman Bernanke's QE policies as the yield curve steepened. The spread was 270+ into summer 2010 when another deflationary scare occurs dropping the spread under 255.  Chairman Bernanke saves the equity markets with QE 2 in August 2010.  In early 2011, the spread is back above 255 favoring the bankers but then in the summer of 2011 the spread falls under 255 and remains under ever since. This summer, the 10-year yield spiked higher and everyone thought the happy banking times were here to stay, and, as typically occurs in markets, this is where the yields reversed dropping the spread from 250-ish back down to 220-ish. Then came the big push higher in the 10-year to near 3.00%. The bankers could not resist; they popped the champagne corks and started drinking. They have been drinking ever since but the yields are only drifting lower (until Friday's bounce) with the spread dancing across the 240's for the last couple months.

Thus, the coast is not clear as yet. Perhaps all the talking heads telling you to buy financials may prove to be correct, however, the charts are not in their favor either. Even though banks may be making money due to the steeper yield curve this does not exactly reflect in the stock price so this must be kept in mind but in a general context, happy banks with happy steeper yield curves make for happy stock prices. The XLF (financials sector ETF) continues to bump along at the highs from July and September lagging the upside move in the broader market. Months ago, pundits exclaimed day after day how financials will lead higher, but they did not. Now the same crew touts the same promises. The stock market simply goes up due to the Fed money-printing.

Traders may be putting the cart before the horse thinking that yields will now continue their upward move non-stop and send bankers and the stock market higher. Wait to see the 255+ spread to see if it is the real deal. Keystone's current projection is continued sideways and sideways lower price action for the financials ahead and the spread will remain under the 255 mark. A period of disinflation and perhaps deflation continues to be a possibility for the next year or two, although Keystone is lonely in this camp. The inflation, and perhaps hyperinflation moves, are likely months and years away. The 18-year stock cycle remains in a secular bear currently until 2018. Even if this is left-translated this time around, that would be 2016-ish as the bottom for the secular bear which may indicate a sick period of disinflation with flat rates continuing for the next 3 years, at a minimum. Watch the 255 number for the 2-10 spread to gauge if the talking heads are correct, or not, and definitely watch the financial tickers XLF (bumping up against 21 for 4 months), $BKX (peaked in June), KRE (regionals making new highs but negatively diverged), GS, BAC, C, MS, etc...

Note Added 11/15/13: The 10-year is 2.71% and 2-year 0.30% for a spread of 241 basis points. The beat goes on.