YIELD CURVE AND STOCKS:
- Wall Street calls the bond market smart money because of its track record of predicting future economic outcomes
- When analyzing the interaction between bonds and stocks, traders often look at the shape of the yield curve to gain insight into the business cycle and predict stock performance.
- There are four basic yield curve regimes: bearish steepness, bearish flattening, bullish steepening, and bullish flattening.
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On Wall Street, traders often say that the the bond market is smart money because of its predictive power for production growth, inflation, and interest rates – three key variables for the wider economy and therefore for financial assets. Based on this perception, investors sometimes focus heavily on bonds, examining the twists and turns of the yield curve, hoping to glean insights into future economic performance and emerging trends. The financial system is highly connected, so it makes sense that the signals emitted by one market can sometimes become an indicator – even a precursor – and a forecasting tool for another that is slower or inefficient in integrating new data.
In this article, we’ll look at the treasury market to explore how the shape/slope of the yield curve can offer clues about expectations for future stock returns and sector leadership by providing insight into the business cycle. Before diving, it is necessary to familiarize yourself with crucial concepts.
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TREASURY YIELD CURVE
the Treasury yield curve is a graphical representation that plots government bond interest rates over different durations for the entire maturity spectrum – overnight to 30 years. It shows the return an investor would get from lending funds to the US government over a given period, with the chart displaying the security’s return on the vertical axis and the borrowing period on the horizontal axis.
The curve can take different shapes, but in healthy environments, it will generally have an upward slope because longer-term debt instruments will offer higher yields than short-term ones to compensate for additional risks such as inflation and duration (see figure below). For example, the 30-year government bond will often have a higher yield than the 10-year note, which in turn should have a higher yield than the 2-year treasury bill.
US YIELD CURVE
Although rare, a long-term security can sometimes underperform a short-term investment, producing a term structure of downward sloping interest rates. When this happens, we say the yield curve inverted.
Frequently, the yield curve tends to invert after the central bank raises short-term rates to avoid overheating to the point of reducing activity and weighing on the economic outlook. When monetary policy has become too restrictive, investors bet that interest rates will have to fall in the future to deal with a possible decline and disinflation. These assumptions cause longer-term bond rates to fall below short-term rates, causing the Treasury curve to invert.
Historically, reversals have often foreshadowed impending recessions. In fact, in the post-WWII era, every inversion of the yield curve (from 3m to 10y or 3m10y) was followed by an economic slump.
INVERTED AMERICAN YIELD CURVE
Rather than focusing on the entire term structure of Treasury market interest rates, Traders often compare two yields at two specific maturities and refer to their spread, measured in basis points, as “the yield curve.” The curves most analyzed and frequently referenced in the financial media are the following:
- The 2-year/10-year curve also known as 2y10y (called two-ten): This is the difference between the yield on 10-year Treasury bills and the yield on 2-year Treasury bills.
- The 3-month/10-year curve also called 3m10y (called three-month-tens): This curve represents the difference between the yield on 10-year Treasury bills and the yield on 3-month Treasury bills.
2s10s and 3m10s curves since 2020
Source: Trading View
EVOLUTION OF THE YIELD CURVE
As economic activity, inflation expectations, monetary policy outlook and liquidity conditions change, the spread between long and short-term Treasury bond yields will also change. When the spread increases, the difference between the long and short rates widens, and the curve is said to be stiffen. On the contrary, when the term spread compresses, we say that the yield curve flatten.
The term spread can change for many reasons; for example, it could flatten because long-term yields fall and/or short-term rates rise (or a combination of both). Twists of the Treasury curve are an effective way real-time economic cycle indicator and can therefore help to develop interesting cross-market trading strategies. For example, sophisticated equity investors will regularly examine the shape and slope of the yield curve to structure an equity portfolio aimed at capturing an emerging economic trend.
THE FOUR DIFFERENT SHAPES OF THE CURVE TO KNOW
Here is a summary of the four fundamental yield curve regimes and how they can help predict sector leadership in the stock market.
- Bear Infuser: long rates increase faster than short rates, accentuating the yield curve. It’s a risky environment which tends to appear during the early stages of the business cycle after a recession after the central bank has lowered the benchmark rate and signaled that it will keep it low for some time to support the recovery. An accommodating monetary policy creates a stimulus context, raising long-term market-determined rates amid improving prospects for future economic activity and inflation. Smart money considers this condition bullish for most stocks and in particular cyclical sectorsdue to faster profit growth. During the steepening of the decline, Materials, Industrials and Consumer Discretionary stocks tend to rally significantly. (Financial) banks, which rely on short-term borrowing and long-term lending, also perform well in these periods thanks to widening net interest margins.
- Bear Crusher: short-term yields rise faster than their long-term counterparts, which compresses term spreads and flattens the curve. This regime takes place during the expansion phase and precedes the fed increase in the federal funds rate to contain inflationary pressures (the front part of the curve is mainly influenced by the monetary policy expectations determined by the central bank). Volatility can sometimes be higher, but this remains a risk environment for stocks with healthy profits. It supports a constructive backdrop for technology, energy and real estate.
- Bull Infuser: short-term yields fall faster than long-term yields, steepening the curve. This regime tends to favor risk and often appears at the onset of a recession when the outlook is highly uncertain and the central bank is cutting short-term rates to stimulate the economy. Overall, stocks do not do well during upswings, although defensive sectors like utilities and staples tend to outperform the broader market as technology and materials struggle.
- Bull crusher: long-term yields fall faster than short-term rates, flattening the Treasury curve. The narrowing of the spread is fueled by downstream moves, driven mainly by market forces amid falling long-term inflation expectations and deteriorating growth prospects. This regime, which portends turmoil in financial markets, breaks out at the end of the economic cycle when investors begin to anticipate a possible recession and disinflation. When bullish flattening prevails, equity investors start shifting their portfolios towards higher quality stocks to hedge against rising volatility. Commodities and utilities take center stage, while cyclicals fare poorly amid weakening corporate earnings in economically sensitive sectors.
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To note: The signifiers “bullish” and “bearish” that describe each regime refer to what happens to bond prices. For example, in bearish flattening, when short-term rates rise faster than long-term rates, short-term Treasuries are sold, causing their prices to fall (bearish for price in this example) . Keep in mind that bond prices and yields move in opposite directions.
The shape of the US Treasuries curve is primarily influenced by inflation expectations, output growth prospects, and monetary policy prospects. Considering that the yield curve captures important variables about the economy today and tomorrow, it is a useful leading indicator of the economic cycle. Based on this assumption, stock investors often use the shape of the curve as a forecasting tool to predict stock market leadership, but this practice should not be done in isolation as bonds can give false signals as with n any tool. That said, top-down and bottom-up analyzes are often best served when creating a balanced report and diversified and less volatile portfolio.
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—Written by Diego Colman, Contributor