Wow, Check Out Those Curves
It was yet another violent day for bonds, as economic data hit a trifecta with
better-than-expected GDP growth, jobless claims and Chicago Purchasing Managers
Index and bonds sold off. But before the day’s trading was over, portfolio
managers, recognizing some good short-term value, started shifting some of their
holdings into bonds. As a result, the equity market rally lost its sparkle and
bonds recouped some of their losses.
What does all of this mean?
In my column yesterday, by performing a simple analysis of the historical
relationship between nominal GDP growth and Treasury yields, we were more or
less able to determine that the sell-off in Treasuries is, to a certain extent
warranted, considering future expectations for economic growth. And as long as
the economic recovery remains in tact–which I expect–the long-term trend for
yields is up. Today, however, I would like to take this analysis one step
further by looking at the relative behavior between Treasuries with different
maturities and determine what this relationship means for both the bond and
equity markets.Â
A yield curve is a line on a graph that connects the yield values of bonds with
different maturities. But to keep it simple, let’s just compare the yield
on the 2 year Treasury with that of the 10 Year Treasury. Currently, the curve
or spread between these two instruments is about 300 basis points (3.00%). As
you can see on the chart below, this is the highest level for the past 28 years.
The reason for this steepness is that Treasuries with longer maturities, such as
the 10 year note, have sold off and the yields–which are inversely related to
price–have gone up, while the 2 year Treasury has remained relatively stable,
and as a result, so has its yield.
More specifically though, the 2 year Treasury has remained stable because of its
proximity–in terms of maturity (2 years)–to the shorter term Fed funds rate,
which according the the Fed, will remain low for an extended period of time due
to disinflation and overcapacity. On the other hand, the 10 Year note is
anticipating good economic times ahead, which, in turn, means higher inflation
and therefore higher short term rates in the future. At some point however, the
10 year and the 2 year notes need to start acting as though they are related to
each other. So either the front end of the curve will move up or the back end
will come down and cool off for a while before moving higher in the months
ahead. Due to the Fed’s current stance on short term rates, I’ll go with the
latter.
What this means for stocks
Typically, steep yield curves are followed by a pickup in economic activity. The
last time the curve was this steep was in 1992, when the Fed cut rates and was
able to engineer an economic recovery. The Fed kept the funds rate steady at 3 %
for 13 months before it embarked on a tightening cycle. This, in turn, kept the
2 year note at a low yield while the 10 year yield rose in anticipation of
economic strength. Six months after the yield curve peaked in 1992, the S&P 500
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PowerRating) was 8 % higher. Steep yield curves have traditionally been good for
cyclical and industrial sectors of the economy.
 ‘
Ed Allen