What Is the Steepening Yield Curve Telling Us?

While the deflation/inflation debate rages on, the jump in U.S. government bond yield (and stronger commodities and weaker U.S. dollar) seems to indicate that deflationary pressures are moderating.

The chart of the U.S. 10-year Treasury Note yield shows a clear uptrend since the end of last year, with the yield also now trading above both the 50- and 200-day moving averages.

Click to enlarge:

Source: StockCharts.com

The graph below shows the relatively flat yield curve (red line) immediately prior to the first rate cut in September 2007. As indicated by the black line, the yield curve has steepened dramatically since as monetary policy kept shorter maturities at low levels while longer maturities have been in a rising trend.

Click to enlarge:

Source: StockCharts.com

A steeper yield curve typically heralds better tidings for economic growth, although concerns about massive issuance also come into play. The graph below shows the close relationship between the U.S. GDP-weighted Purchasing Managers Index (PMI) and the U.S. 10-year Treasury Note yield.

Click to enlarge:

Source: Plexus Asset Management (based on data from I-Net Bridge)

This raises the question as to what the impact of the yield curve typically is on the stock market. The blue line in the chart below shows the U.S. 10-year Treasury Note yield relative to the U.S. 2-year Treasury Note yield. A rising blue line indicates a steepening yield curve, whereas a downward trend shows the opposite. A comparison with the S&P 500 Index highlights a broadly inverse relationship, i.e. stocks fall when the yield curve steepens and rise when the curve flattens.

Click to enlarge:

Source: StockCharts.com

A key observation, however, is that the stock market usually bottoms prior to a peak in the yield curve, i.e. as confidence regarding an economic recovery gains ground and earnings prospects improve.

Importantly, the steepening of the yield curve comprises two phases: firstly, when both short- and long-term rates fall but short rates fall more than long rates as a result of poor economic conditions and, secondly, when long rates start discounting better economic prospects but short rates are still kept at low levels. The subsequent decline in the yield curve is when both short and long rates increase, but short rates rise faster than long rates. Share prices typically rise during the second phase of the steepening of the yield curve and the ensuing decline.

The above analysis is merely one cog of the wheel, but seems to support the argument that U.S. stocks are in all likelihood in a broad bottoming-out phase. As said before, investors will now focus on the second-quarter earnings reports as a test of whether stock prices bear resemblance to fundamental reality. In the meantime, a cautious approach is warranted but that should not preclude one from finding stocks that look cheap.

Comments

[nobby73:]

The steepening yield curve is telling us there is huge volumes of issuance and appetite is stronger at the shorter end of the curve, owing to uncertainty over inflation and the direction of the dollar.

Jul 22 03:54 AM

[TradingHelp...:]

A steep yield curve is just normal at this stage of the economic cycle with rates currently low but inevitably to rise?

I would be concerned if the yields were flat, but not as they are now rising into the horizon.

Excellent article as always.

Jul 22 04:33 AM

[Dave Wrixon:]

Ultimately inflated book values will not pay dividends, so the truth will out sooner than most think.

Jul 22 06:17 AM

[hksche2000:]

Great work, as always. Keep it up.
Thanks!

Jul 22 11:59 AM

[RiskAverseA...:]

Prieur: what is the 200-day moving average on the 10 year doing? Why are monstrous Treasury auctions being met with strong demand?

Deflationary pressures do not appear to be moderating. Indeed, the collapse of the securitization market -- the engine for creating hundreds of trillions of dollars of fools gold that became more addicting than heroin -- speaks loud and clear. The private financial sector's ability to inflate paper assets has been killed.

Likewise, the collapse of the physical economy -- somewhat masked by foreign-produced butter extorted using big guns -- will put a limit on Treasury's ability to infinitely issue new debt in the present attempt to mitigate the collapse of Wall Street's structured finance. Therefore, our nation's present exercise in fantasy, pretending the financial system is anything but bankrupt, will in the end prove futile. Simply put, the private sector's former "Inflate or Die" mantra cannot be resurrected on public account.

Yet, short of bankruptcy reorganization of the entire global system, financial obligations will persist. And there are millions more Lenny Dystras out there whose inability to roll over liabilities will find little sympathy with the bankers at JP Morgan Chase. Whatever isn't nailed down will be sold.

Jul 22 12:01 PM

[FB5000:]

Please allow me to summarize

Flat yield curve = dangerous to buy stocks. Associated with tops
Steep yield curve = safe to buy stocks. Associated with bottoms

Short term money is fuel - cheaper more plentiful fuel = growth - long term money indicates future inflation level - a moderate level is ok - too much is bad. The Fed is holding down the short end of the curve and creating conditions for growth. The good news now is that the long end is staytinf below 4%. Minimal inflation = a benign environment

Investors like Treasuries because the U.S market is broad and deep and stable. And prospects in the U.S despite what the lemmings say are decent. Witness China's inability to sell debt. China is the boom economy yet who would like to buy yuan denominated debt - really? Until they begin to look more like the U.S they will find it difficult and investors will vote with their feet.

That's all.

Jul 24 09:10 AM