YIELD CURVE AND STOCKS:
Wall Street and the Bond Market
Wall Street traders and investors often refer to the bond market as the “smart money” due to its track record of accurately predicting future economic outcomes. They recognize that the bond market provides valuable insights into economic growth, inflation, and interest rates – all of which are crucial variables for the broader economy and financial assets.
Importance of the Yield Curve
When analyzing the interplay between bonds and stocks, traders pay close attention to the shape of the yield curve. The yield curve is a graphical representation of the interest rates on government bonds with different maturities, ranging from overnight to 30 years. It offers valuable information about the expectations for future equity returns and sector leadership, as well as insights into the business cycle.
Understanding the Yield Curve Regimes
There are four fundamental yield curve regimes that traders and investors need to understand: bear steepener, bear flattener, bull steepener, and bull flattener.
- Bear steepener: During a bear steepener regime, long-term rates increase at a faster pace than short-term rates, resulting in a steepening of the yield curve. This usually occurs during the early stages of the business cycle following a recession. It is a risk-on environment where the central bank has cut interest rates and signaled a prolonged period of low rates to support economic recovery. The smart money considers this condition bullish for most stocks, particularly cyclical sectors, due to the potential for faster earnings growth. Materials, industrials, and consumer discretionary stocks tend to perform well during bear steepening, along with banks (financials) that benefit from widening net interest margins.
- Bear flattener: In a bear flattener regime, short-term yields rise at a faster rate than long-term yields, causing the yield curve to flatten. This usually occurs during the expansion phase of the business cycle when the central bank raises the federal funds rate to curb inflationary pressures. Despite the potential for higher volatility, this remains a risk-on environment for stocks, supported by healthy earnings. Technology, energy, and real estate sectors tend to thrive during a bear flattener regime.
- Bull steepener: When short-term yields fall faster than long-term yields, it creates a bull steepener regime. This typically occurs during the early stages of a recession when the economic outlook is uncertain, and the central bank cuts short-term rates to stimulate the economy. Stocks don’t perform well during bull-steepening periods, but defensive sectors like utilities and staples tend to outperform the broader market. Technology and materials sectors may struggle during this period.
- Bull flattener: In a bull flattener regime, long-term yields fall at a faster rate than short-term yields, leading to a flattening of the yield curve. This narrowing spread is driven by market forces as long-run inflation expectations decline and the growth outlook deteriorates. This regime often emerges late in the business cycle, as investors start pricing in a possible recession and disinflation. When bull flattening prevails, equity investors tend to shift their portfolios towards higher quality plays as a hedge against rising volatility. Staples and utilities sectors usually outperform, while cyclicals struggle due to weakening corporate earnings for economically sensitive sectors.
TREASURY YIELD CURVE
Representation and Interpretation
The Treasury yield curve represents the interest rates on US government bonds with different maturities. It provides a comprehensive view of the return an investor would earn by lending funds to the US government for a specified period. The curve shows the security’s yield on the vertical axis and the borrowing period on the horizontal axis.
Shape and Slope of the Curve
The Treasury yield curve can take various shapes, but in healthy environments, it typically slopes upwards. This means that longer-term debt instruments offer higher returns than short-dated ones to compensate for additional risks such as inflation and duration. For example, the 30-year government bond often has a higher yield than the 10-year note, which in turn, should have a higher yield than the 2-year Treasury note.
U.S YIELD CURVE
Inverted Yield Curve
Although rare, there are times when a long-term security may have a lower yield than a short-term investment, resulting in an inverted yield curve. Inversions of the yield curve tend to occur after the central bank has raised short-term rates to prevent the economy from overheating. When monetary policy becomes too restrictive, investors anticipate future rate cuts to address a possible downturn and disinflation. As a result, longer-dated bond rates fall below short-term rates, leading to an inverted Treasury curve.
Recessions and Inversions
Historically, yield curve inversions have often foreshadowed impending recessions. In fact, since World War II, every yield curve inversion (specifically the 3-month to 10-year spread) has been followed by an economic slump. This is why investors pay close attention to the shape and slope of the yield curve as an indicator of future economic performance.
INVERTED U.S. YIELD CURVE
Comparing Yields at Specific Maturities
When analyzing the yield curve, traders often compare the yields at two specific maturities and refer to their spread as “the yield curve.” The most analyzed and referenced curves are:
These curves provide additional insights into the relationship between short-term and long-term interest rates.
CHANGES IN THE YIELD CURVE
Impact of Economic Factors
The spread between long and short-term Treasury yields can change due to a variety of economic factors. Changes in economic activity, inflation expectations, monetary policy outlook, and liquidity conditions all contribute to the shifting spread. When the spread increases, the yield curve steepens, indicating a widening difference between long and short-dated rates. Conversely, when the spread compresses, the curve flattens.
Real-time Business Cycle Indicator
The twists and turns of the Treasury yield curve serve as a real-time indicator of the business cycle. As a result, they can help traders develop cross-market trading strategies. Sophisticated stock investors often examine the shape and slope of the yield curve to structure an equity portfolio and capture emerging economic trends.
THE FOUR DIFFERENT SHAPES OF THE CURVE TO KNOW
Bear Steepener
A bear steepener regime occurs when long-term rates increase faster than short-term rates, steepening the yield curve. This signals a risk-on environment and typically appears during the early stages of the business cycle following a recession. Central banks cut benchmark rates and signal long-term low rates to support recovery. Accommodative monetary policy creates a reflationary backdrop, leading to market-determined long-term rate increases. This condition is considered bullish for most stocks, especially cyclical sectors that experience faster earnings growth. Materials, industrials, and consumer discretionary stocks often rally significantly during a bear steepening period. Banks also perform well due to widening net interest margins.
Bear Flattener
A bear flattener regime occurs when short-term yields rise faster than long-term yields, resulting in a compression of the term spreads and a flatter yield curve. This regime typically takes place during the expansion phase of the business cycle, preceding the Federal Reserve’s hikes of the federal funds rate to manage inflationary pressures. Despite potential higher volatility, this remains a risk-on environment for stocks, supported by healthy earnings. Technology, energy, and real estate sectors tend to benefit during a bear flattener period.
Bull Steepener
A bull steepener regime occurs when short-term yields fall faster than long-term yields, steepening the curve. This regime is usually risk-off and often appears early in a recession when the economic outlook is uncertain. Central banks cut short-term rates to stimulate the economy during this period. Stocks generally don’t perform well during bull-steepening periods. Defensive sectors like utilities and staples tend to outperform the broader market, while technology and materials struggle.
Bull Flattener
A bull flattener regime is characterized by long-term yields falling faster than short-dated rates, flattening the Treasury curve. The narrowing spread is driven by market forces, reflecting falling long-run inflation expectations and a deteriorating growth outlook. This regime typically occurs late in the business cycle when investors begin pricing in a potential recession and disinflation. During a bull flattening period, equity investors shift towards higher-quality plays as a hedge against rising volatility. Staples and utilities sectors often lead the way, while cyclicals struggle due to weakening corporate earnings for economically sensitive sectors.
Conclusion and Considerations
The shape and slope of the U.S. Treasury yield curve provide valuable insights into economic trends and potential stock market leadership. However, it is important to note that the yield curve should not be used in isolation to make investment decisions. It is just one tool among many in the analysis process. Other factors such as market sentiment, company fundamentals, and geopolitical events also play a role in determining stock market performance.
Traders and investors are encouraged to use a balanced and diversified approach when interpreting the yield curve and making investment decisions. By combining top-down and bottoms-up analysis, market participants can gain a more comprehensive understanding of the current economic environment and make informed investment choices.
Remember that the yield curve’s four different shapes – bear steepener, bear flattener, bull steepener, and bull flattener – provide valuable insights into sector leadership and can help guide investment strategies. However, it is always important to conduct thorough research and consider multiple factors when making investment decisions.
For traders interested in furthering their knowledge, numerous educational tools and resources are available. These include quarterly equity forecasts, trading personality quizzes, and valuable market sentiment indicators.
Written by Diego Colman, Contributor