The 2 And 10-Year Yield Spread: And The Different Messages

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Includes: BAC, SPY, TLT, XLF
by: Chris B Murphy

Summary

The 2-year and 10-year yields are both down, but different percentages and for different reasons.

The unlikely chance of a March Fed hike is affecting the 2-year while uncertainty surrounding Trump policies and growth are impacting the 10-year.

Going forward, we'll need to dig deep and parse out the different reasons for the disparity in yields as it will impact investors differently.

Since last year, Treasury yields have been rising at breakneck speed. Inflation and growth expectations, as well as a resulting Fed hike, have largely been the cause.

The election of Donald Trump and his promise of fiscal stimulus has also added fuel to the fire going on in the bond market.

Also, the yield spread between the 2-year and the 10-year Treasury has been rising as yields surge for both short-term and long- term securities.

But what do rising yields mean for the economy and the markets in general? And what if short-term yields and long-term yields don't move in lockstep?

When looking to enter a position in the stock, it's helpful to understand not only whether Treasury yields are rising, but also which maturities are rising.

This article is a continuation of an ongoing series analyzing the impact of yields, Fed hikes and economic growth have on the markets.

Volatility in Treasury yields impact investors who have positions in bonds via the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT). And since yields have been an integral part of the equity rally and surge in financial stocks, volatility will also impact those investing in the SPDR S&P 500 Trust ETF (NYSEARCA:SPY), bank stocks like Bank of America Corporation (NYSE:BAC), and financial ETFs like the Financial Select Sector SPDR ETF (NYSEARCA:XLF).

The 2-Year & the 10-Year Yield:

As we can see, yields have been on the rise since the summer of 2016 and surged following the election. President Trump is not the only factor affecting yields since they were rising before the election.

As of late, yields are coming off their highs, but they're behaving differently. This is true because different factors affect short and long-term maturities.

10 Year Treasury Rate Chart

10 Year Treasury Rate data by YCharts

The 2-year yield is typically driven by the Fed Funds Rate and is most sensitive to interest rate changes by the Fed. The 10-year yield is driven by the market and reflects inflation and growth expectations in the long-term.

In looking at the percentage change in yields from the peaks of this recent yield rally (bond market sell-off), the 2-year yield has fallen over 7% while the 10-year is off almost 6%.

10 Year Treasury Rate Chart

10 Year Treasury Rate data by YCharts

Why the 2-year yield is down from its highs:

A possible explanation for the drop in the 2-year yield is that market expectations for a Fed hike in March are lower, driving down short-term rates like the 2-year.

If the Fed is expected to hold off hiking rates, investors pour in and buy short-term Treasuries like the 2-year since they want to lock in the current yield.

Conversely, if the Fed were to hike in March, the bond market would sell off (sending prices lower and yields higher). A Fed hike makes current 2-year yields worth less in value. Investors would unwind their current Treasury positions and wait to purchase the higher yielding bonds following the Fed hike.

Also, the auction for new issues of the 2-year Treasury had solid demand.

"The demand on the 2-year is the highest since August." - CNBC

Further increases in demand for the 2-year will likely spike bond prices and send yields lower.

It will be interesting to watch as the mid-March Fed meeting comes and goes, where the 2-year is trading. And with the May and June Fed meetings approaching, we're likely to see increased volatility in the 2-year as the market speculates as to which meeting will most likely contain a hike.

Why the 10-year yield is down from its highs:

In addition to dealing with lower rate hike expectations in the short-term from the Fed, the market may also be reducing inflation and economic growth expectations.

Uncertainty surrounding President Trump's fiscal stimulus and tax cuts and also whether any legislation will get passed by Congress by the end of the year have weighed heavily on the markets. If hopes dim further and expectations of a stimulus get pushed out to next year, look for the 10-year yield to correct lower.

The spread between the 2s and 10s is down over 10% since the highs following the election; further emphasizing the prevailing uncertainty in the market.

Ideally, we want to see yields rising signaling a positive outlook for the economy. If yields continue to fall and spreads widen further, equities may falter, particularly bank stocks since banks are interest-rate sensitive.

10-2 Year Treasury Yield Spread Chart

10-2 Year Treasury Yield Spread data by YCharts

Any downside in yields should have a floor.

It's doubtful we'll see the lows in yields set last year as any correction should be limited somewhat. Without a huge negative market event, the Fed will hike, and the economy should continue to grow.

The economic fundamentals should provide a floor for yields as it's not a matter of whether the Fed will hike, but rather, when. The current market is struggling with timing and expectation issues.

Final takeaway:

With the financial crisis behind us and economic growth stable, the economic growth theory of "a rising tide lifts all boats" has become obsolete. We're no longer desperate for just any increase in jobs, GDP or even Fed hikes. The market and investors are shifting to a more industry or sector-specific style of investing. Economic growth, easy or tightening monetary policies and political outcomes will likely impact sectors and markets differently.

As a result, events will impact you and me differently. Parsing out data and news that applies to your investments and risk tolerance will be important going forward. No longer can we simply say if yield spreads are rising, we'll earn capital gains on equities or banks, etc. In today's market, we need to dig deeper. As in the case of the yield curve, we'll need to bifurcate the 2-year and 10-year Treasury yield movements to get a complete picture of the what's driving the market. It's a little harder, and more work as we get inside the numbers, but I think you'll find it'll be worth it, and it should yield better returns.

More to follow on yields, financials and risk management techniques designed to prevent that dreaded "bad' trade. If you like this article and would like to read more of my market analysis, please click the 'Follow" button to the right of my name at the top of this article.

Good luck.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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