If you’re looking for a brusque, no-nonsense guide to the state of the financial markets in 2022, spend a minute with the yield curve. At confusing times – like now – it cuts through the clutter.
For starters, it gives early warning of U.S. recessions ahead. Even better, it offers important clues about how the stock market will perform in coming months.
An intriguing chart from Stéfane Marion and Matthieu Arseneau at National Bank Financial shows the surprising strength of this relationship. Shifts in the U.S. yield curve are closely tied to how the Canadian and U.S. stock markets will perform over the next six months, according to their research, which covers data from 1973 onward.
Why is the U.S. Treasury yield curve flattening and what does it mean?
Making sense of this first accompanying chart may require a bit of explanation. For starters, remember that the yield curve is essentially a way to measure the difference in yields between long-term bonds and short-term bonds.
In the chart, the National Bank economists focus on the gap between 10-year U.S. Treasuries and three-month U.S. Treasury bills. (You can track this figure yourself by visiting fred.stlouisfed.org, the data website run by the Federal Reserve Bank of St. Louis, and searching for “10-year minus three-month”.) Mr. Marion and Mr. Arseneau demonstrate that shifts in this gap are closely tied to future stock returns. The bigger the gap, the better the likely returns.
Return of equities vs. slope of yield curve
Slope of U.S. yield curve during mature phase
and average return in six months following
Average six-month return, %
12.5%
S&P 500
S&P/TSX
8.7%
5.4%
2.5%
1.8%
0.7%
-5%
-9.1%
<-50 bps
>-50 to < 0
> 0 to < 100
>100 bps
Yield curve: 10-year minus three-month T-bill (bps=basis points)
the globe and mail
source: National bank financial
Return of equities vs. slope of yield curve
Slope of U.S. yield curve during mature phase
and average return in six months following
Average six-month return, %
12.5%
S&P 500
S&P/TSX
8.7%
5.4%
2.5%
1.8%
0.7%
-5%
-9.1%
<-50 bps
>-50 to < 0
> 0 to < 100
>100 bps
Yield curve: 10-year minus three-month T-bill (bps=basis points)
the globe and mail
source: National bank financial
Return of equities vs. slope of yield curve
Slope of U.S. yield curve during mature phase and average return in six months following
Average six-month return, %
12.5%
S&P 500
S&P/TSX
8.7%
5.4%
2.5%
1.8%
0.7%
-5%
-9.1%
<-50 bps
>-50 to < 0
> 0 to < 100
>100 bps
Yield curve: 10-year minus three-month T-bill (bps=basis points)
the globe and mail, source: National bank fibancial
At the time of writing, the difference between 10-year Treasuries and three-month issues stands at 138 basis points, or 1.38 percentage points. (A basis point is equal to one-hundredth of a percentage point.) Judging from the economists’ chart, the current 100-basis-point-plus gap offers reason to think stocks are still capable of producing decent returns over the next six months. To be sure, this picture could change quickly as central banks start raising key interest rates, but for now, the signs from the bond market are positive.
Why should bond yields have so much to say about the stock market? It has to do with how the yield curve changes shape to reflect the state of the economy.
Start with the fundamentals: The yield curve is what you see if you construct a chart that shows how yields vary for bonds that mature at various dates in the future. If you list the maturity dates in order along the bottom of the chart, and you plot the yields for each vintage of bond directly above the maturity date, you get a line that nearly always curves upward.
Yields start out low at the three-month point because only a small amount of risk is involved in tying up money for such a short period. Investors therefore don’t require a big payoff. Yields rise, though, as investors are asked to commit their money for longer and longer periods. Five-year bonds must shell out more than short-term bonds to attract buyers. Ten-year bonds must pay even more. Thirty-year bonds must tempt investors with the biggest yields of all. This creates a yield curve that nearly always tilts upward.
But here is where things get interesting: While the yield curve normally bends upward, its slope isn’t fixed. At any given moment, how steep the curve is depends on what investors expect from the economy in coming years.
The steepest yield curves usually occur when an economy is just emerging from recession. Short-term interest rates and short-term bond yields are low at that point because the economy is in the dumps. However, yields on longer-term bonds are typically much higher, in part because future interest rates are expected to rise in tandem with a recovering economy. This creates a situation where the yield curve is tilted sharply upward and the gap between long-term and short-term yields is unusually high.
The curve usually flattens as a recovery matures. The gap between long-term yields and short-term yields grows narrower.
On rare occasions, the yield curve can even invert – that is, short-term rates can break the normal pattern and move higher than longer-term rates. This typically happens only when investors smell economic danger ahead – often because central banks are aggressively raising short-term rates to throttle back hot economies. Over the past four decades, an inverted yield curve has proven to be a freakishly accurate indicator of U.S. recessions ahead.
What does the yield curve say now? Analysts usually look at the 10-year Treasury yield minus the two-year Treasury yield to figure that out. As the second accompanying chart makes clear, the gap between these two yields has narrowed dramatically in recent months and now sits well below one percentage point – a level that is getting toward flat although not there yet.
This suggests that the current recovery is now in a mature stage. It doesn’t necessarily signal apocalypse ahead – a flattening, or even flat, yield curve can trundle along for years, as happened in the 1990s. But it does signal that the economy is more vulnerable than it may appear and that this business cycle may be unusually short.
Investors should be aware of both the risks and the rewards. At current levels, the yield curve is positive about what lies ahead for stocks. But further flattening of the yield curve would mean that the outlook for both stock prices and the economy is growing darker. To gauge how this picture is evolving, make it a habit to check in regularly on the yield curve in 2022.
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Ian McGugan