Stephen Gandel is a Bloomberg columnist.
Do flat times in the bond market always mean the same for stocks? That's the latest question testing the bull market, which has propelled stocks up for more than eight years and 16 per cent so far in 2017.
The Treasury yield curve, which measures the difference between shorter– and longer-term U.S. government debt, such as two-year and 10-year Treasuries, has been flattening for a while. But the fact that the narrowing has accelerated recently, and that there is not much room left between the two rates, could be a growing concern for stock investors. A month ago, 10-year Treasuries were yielding 0.86 percentage points more than two-year notes. That's already not much of a return for lending money for an additional eight years. But by the close of day on Wednesday, the difference between the two rates narrowed to just 0.67 percentage points. That last time the gap was that small was November, 2007, just before the Great Recession.
The problem is that a flat yield curve often suggests a recession is on the horizon. The yield curve is typically upward sloping, with long-term bonds paying higher interest rates than shorter ones. The reason is based on the assumption that growth and therefore inflation will be higher in the future. But when bond investors expect slower growth, or little inflation, they buy longer-term bonds, pushing their prices up and their yields down. The result can be a flat yield curve or even an inverted one. Historically, a flat yield curve is a bad sign for the economy and an inverted one is deadly.
The current flattening of the yield curve has come as something of a surprise. Most people thought it would widen this year. Last week, the monthly jobs report showed that unemployment hit a new low. And stock investors certainly don't anticipate a recession. The average stock in the S&P 500 Index trades at a price-to-earnings ratio of 19.5 based on this year's expected earnings. That's higher than average, suggesting that investors are relatively certain corporate profits will grow, not plunge in a recession.
Nonetheless, the disconnect between the outlook for the stock and bond markets is worrying. Stock investors could be wrong. What's more, a flat yield curve is bad for banks, which derive a good part of their revenue from the difference in rates – collecting money from depositors at short-term rates and lending to say home buyers at much longer ones. Bank stocks make up the largest percentage of the S&P 500, nearly 20 per cent.
But the flat yield curve may not be as bad a signal as it appears. First, the stock and bond markets have disagreed before. For example, the yield curve went completely flat in 1998 before widening again. It was two and a half more years before the recession hit. The yield curve was also flat in early 2006. One could say the bond market hasn't been wrong, it's just been early.
Second, many think the yield curve's predictive power is not what it once was. Central banks, which have been buying and holding onto bonds, are distorting the yield curve. The Federal Reserve has recently been raising short-term rates while the European Central Bank has stepped up its bond-buying efforts. That's pushed more investors looking for yield in government bonds to the United States. Merrill Lynch strategists have dubbed the latest move in the bond market a "bull market flattening."
Last, history suggests stock investors really don't have to worry that much about a flat yield curve. Stocks have generally done worse when the yield curve has gone completely flat or negative. But other than that, the yield curve hasn't been a great predictor of where the S&P 500 is headed. For instance, in 1990, the difference in two and 10-year Treasury yields was just 0.42 percentage points, or 0.25 percentage points narrow than now. The S&P 500 returned more than 30 per cent the following year. In fact, stocks have generally done well at relatively low yield spreads.