How to tell whether the yield curve is about to throw the markets a fastball

For all of their ongoing enthusiasm for the reflationary ‘Trump’ trade, stock markets have stopped going up and bond markets have stopped going down on both sides of the Atlantic, at least for the moment. To further muddy the waters, the dollar has weakened and gold poked its head back above the $1,200-an-ounce mark.

Despite the misgivings voiced in last week’s column, about how US stocks trade at near all-time high valuations, US firms are making record profits and American equity markets are exhibiting unusually low levels of volatility, it may not pay to jump to too many conclusions, even if great care is needed.

One way in which investors can test the economic and stock market temperature in the US and UK is to look at the yield curve. In essence this measures the difference in yield between the yields on government bonds with different maturity profiles.

In theory, a bond with a longer maturity should offer a higher initial coupon than a bond with a shorter lifespan to compensate for the higher risk posed by how the payments are more back-ended loaded.

As such, the yield curves on offer in the US and UK look relatively normal:

Source: Thomson Reuters Datastream

However, the real area of interest is the gradient of the slope and – more particularly – how it changes over time.

Although the trend has become more acute since President Trump’s election, the yield curve has been steepening since late spring in 2016. This makes sense as a steeper curve is normally taken as a sign of economic growth and inflation ahead. Markets price in future interest rate increases – and talk of infrastructure spend and fiscal stimulus in the UK, Japan, Canada and US fits with that pattern.

History is less clear cut on whether a steeper curve is good for share prices. Strong growth and rising inflation and higher interest rates can mean higher corporate earnings but also lower valuations as the relative attraction of equities relative to cash and bonds slips while yields on safer assets rise and cash flow-based valuation models incorporate higher discount rates.

For the moment, markets are happy to see a steep (and steepening) curve, not least because they are never pleased to see an inverted one, where near-term yields are higher than longer-term ones. That has been a pretty reliable indicator of an economic slowdown, even a recession, not to mention a stock market stumble.

Three phases

In general terms, the yield curve has three classic shapes:

• Steep or steepening, whereby longer-term bond yields are higher than those available from near term paper. This is really how it should be, given the relative risk profiles and when economies are doing well – or expected to gather momentum – long-term yields can rise faster than short-term ones, steepening the curve.
• Flattening, whereby the premium yield available on longer-term paper starts to shrink. A “bull” flattener occurs when short-term yields are rising faster than long-term ones, as the economy and corporate earnings gather traction. At this time of the cycle, stocks, and especially cyclical areas like mining, industrials and retailers, do well, alongside commodities, while bonds start to struggle. A “bear” flattener develops when long-term rates are falling faster than short-term ones, as the market prices in interest rate cuts in anticipation of an economic slowdown. At this stage of the cycle bonds and defensive equity sectors like utilities, pharmaceuticals, telecoms and consumer staples have traditionally done best.
• Inverted, whereby the yield on long-term bonds goes underneath that of short-term paper as the market prices in a deep economic slowdown, interest rate cuts and even a recession. Cash and bonds have tended to do best here, with equity income faring relatively well compared to other strategies (with the emphasis on relatively).

These shifts in the shape of the yield curve can be followed in two ways:

• In long-hand, it is possible to draw the full curve, ranging from say one- to thirty-year paper and showing how the curve changes at regular intervals (daily, weekly or monthly).
• In short-hand, by comparing the yield relationship between 2-year and 10-year Government bonds. This so-called “2s10s curve” uses the 2-year paper, as this is often seen as a good proxy for near-term central bank monetary policy, and the 10-year, as this is a broader benchmark for all Government debt.

Shape-shifter

This column has therefore looked at US data back to the early 1980s and UK data back to the mid-1990s to see if the yield curve has been a helpful indicator for investors when it comes to portfolio construction.

Let us begin with the USA, since the enthusiasm for President Trump’s proposed package of tax cuts, infrastructure spending and deregulation is drawing favourable comparison with Ronald Reagan, who was President from January 1981 to January 1989. By the third year of Reagan’s first term US GDP growth was running at around 8% and the yield curve had steepened consistently as the bond market responded to ‘The Gipper’s’ programme of reforms.

Since then, the US yield curve has steepened markedly on another six occasions and the only false signal came in 2008 as America tipped into recession following the collapse of the sub-prime mortgage market. Central bank intervention, in the form of interest rate cuts and then Quantitative Easing (QE) in some ways distorted the curve as the Federal Reserve sought to keep short-term interest rates low and steepen the yield curve with the aim of helping banks to borrow cheaply and lend more expensively, so they could pocket the difference and rebuild their profits and balance sheet in the process.

Steeper US yield curve has usually correctly pointed to better growth

Source: Thomson Reuters Datastream

The prospect of central bank intervention is the one real knock on the yield curve, especially as zero interest rate policies (ZIRP), QE and interest-rate manipulating policies like Operation Twist were all designed to make the bond market bend to the iron will of the Fed.

The curve flattened markedly in 2015 as growth fears gathered, the Fed stopped adding to QE and then began to raise rates, so the central bank will doubtless tread carefully with any further moves to tighten policy. It is clearly wary of doing too much too soon, even if there is no sign of the classic ‘recession’ signal right now, namely an inverted yield curve. The curve inverted in 1989, 2000 and 2007 to give an accurate warning that tougher times lay ahead.

Inverted US yield curve has accurately warned of recessions three times in the past two decades

Source: Thomson Reuters Datastream

The yield curve has given some strong and accurate signals in the UK over the past 20 years, too. ‘Steepeners’ in 1999 and 2001-3 foretold of strong economic growth under the Blair-Brown Labour administration while even the 2012-13 steepening was followed by some improvement in economic momentum even if ZIRP and QE from the Bank of England served to anchor the short end.

Steeper UK yield curve has also usually pointed to faster GDP growth ahead

Source: Thomson Reuters Datastream

An inverted curve in 1998 flagged the dangers of the Asian debt crisis – through which Britain sailed relatively unscathed and warned of the problems which lay ahead in 2007-08 as the Global Debt Crisis brewed.

An inverted UK yield curve has also usually pointed to trouble ahead

Source: Thomson Reuters Datastream

Market message

This is all well and good but as experienced investors know, the state of the UK economy does not always have too much bearing upon the fate of the FTSE 100, as two-thirds of the benchmark’s earnings come from overseas, or by implication the FTSE All-Share, which derives more than 80% of its market cap from the megacap FTSE 100 index.

The yield curve’s record when it comes to market predictions is therefore understandably spottier.

Steepeners in 1998, 2008 and 2012 correctly pointed to stock market advances in the UK, as has the steeper curve seen since spring 2016.

Yet 2001-3 was no use as the FTSE All-Share collapsed, weighed down by the bursting of the tech, media and telecoms bubble, though this was more likely a “bear” steepener, the result of short-term yields collapsing as the Bank of England slashed interest rates, rather than long-term yields going up faster than near-term ones.

A steep UK yield curve has helped spot some equity bull runs but it has given false signals too

Source: Thomson Reuters Datastream

As with the economy, an inverted yield curve seems to be the equity equivalent of Blind Pugh’s Black Spot in Stevenson’s Treasure Island. The subsequent economic slowdowns weighed heavily on corporate earnings growth and took a toll on share prices:

An inverted UK yield curve has warned of two stock market stumbles since 1996

Source: Thomson Reuters Datastream

A similar pattern can be discerned in the USA.

Of eight discernible steep curves since 1983, five have preceded bull runs in the S&P 500. All saw long-rates rise faster than short-term ones.

The three exceptions were all “bear” steepeners, where short-term rates fell sharply in response to Federal Reserve interest rate cuts, which came in response to the Asian debt crisis of 1997-98, the collapse of the tech bubble in 2001-03 and then the sub-prime catastrophe of 2007-09.

A steep US yield curve is hit and miss as a stock market predictor

Source: Thomson Reuters Datastream

However, the much-rarer inverted curve is three for three since 1983 when it comes to nailing a stock market downturn.

An inverted US yield curve has been a reliable sign of danger for equity markets

Source: Thomson Reuters Datastream

Conclusion

The chances of us seeing an inverted yield curve in the UK or US (or Japan, the EU or Switzerland) seems remote for now, as central banks are still heavily involved in trying to manage lower bond yields and the cost of money through NIRP, ZIRP or QE schemes – with the possible exception of the USA, where interest rates are crawling higher at a snail’s pace.

The real test will come when – if - central banks begin to unwind and sterilise their QE schemes, although there seems little chance of that when the central banks of UK, EU and Japan are still adding to the QE bond-buying haul.

That does question whether a steeper curve can be relied upon, if central banks are trying to control bond markets so its more ominous opposite does not appear.

For the moment, stock markets are welcoming a steeper curve, seeing it as a positive for banking and insurance stocks in particular, and also for those firms with big pension deficits.

One warning sign would therefore be if 10-year yields start to drop again. Two-year yields will be anchored by central bank policy so any drop would provide not an inverted yield curve but potentially a “bear flattener”. That would be a big test for cyclical, value equity sectors, raw material and commodity prices and emerging markets assets – in other words the big beneficiaries of the Brexit and Trump trades of the last nine to ten months.

The row with the US judicial system over the proposed temporary seven-nation travel ban has sown the first seeds of doubt in the market’s mind about whether Trump can deliver what he has promised, as 10-year Treasury yields have fallen. Investors need to watch the trend in US (and UK) 10-year Treasury and Gilt yields, especially when the President locks horns with the House of Representatives and the Senate over tax and spending plans.

Russ Mould, AJ Bell Investment Director.