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The yield curve is often cited as one of the market’s best leading indicators and rightfully so. The yield curve has been one of the more reliable economic indicators. An inverted yield curve, which occurs when long-term bond yields are lower than short-term bond yields, has proceeded each of the last five recessions.
In normal times, the yield curve is upward sloping with longer term bond yields exceeding those of short-term bond yields. The greater the difference between long-term and short-term yields, the “steeper” the yield curve. Conversely, when the yield differential is narrow the yield curve is said to be “flat”. As we start 2010, the yield curve is at a record-breaking steep level as measured by comparing the difference between 2- and 10-year Treasury yields [Chart 1].
Since the yield curve is a leading indicator its current shape reflects bond market expectations for the future. A steep yield curve reflects expectations of future economic growth. Note the last two times the yield curve was at such a steep level real GDP exceeded 4% [Chart 2]. To that point, the yield curve was very steep throughout 2009 and fourth quarter GDP is on pace to expand 4% or more.
Along with positive economic growth expectations, a steep yield curve also reflects higher future inflation and the fact that higher yields are needed to entice an investor to buy longer-term bonds. The bond market is comfortable with some inflation which is (as opposed to deflation) is desirable for the economy. The degree to which the market is comfortable with inflation expectations will influence the steepness of the yield curve. However, the yield curve is influenced by both the Fed and inflation so by itself the yield curve has not been a good predictor of future inflation. The steep yield curve merely reflects a continuation of positive inflation that accompanies economic growth.
It’s All About the Slope
The slope of the yield curve is primarily influenced by two factors: the Federal Reserve (the Fed) and inflation. The Fed influences shorter-term yields using the Fed funds rate while market participants’ inflation expectations dictate the longer-term 10- and 30-year yields. The intermediate 5- to 10-year segment of the yield curve often acts a fulcrum.
The inflation-adjusted, or real, Fed funds rate combines Fed monetary policy and the level of inflation. The more Fed policy is viewed as stimulative to the economy by the bond market, the steeper the curve, and vice versa. The extremely low Fed funds rate of 0% to 0.25% is intuitively stimulative but the inflation-adjusted, or real, Fed funds rate (which subtracts core Consumer Price Index (CPI) from the Fed funds rate) is the best gauge of how loose/ restrictive Fed policy is. The real Fed funds rate is highly correlated with the shape of the yield curve. The real Fed funds rate also points to record-breaking steepness of the curve.
Treasury issuance and benign comments from Fed officials have also influenced the yield curve recently. The Treasury recently stated its desire to shift the average maturity of outstanding Treasury debt from an average of 48 months, near a historic low, out to an average of 60 to 72 months over coming years. This implies greater issuance of longer 10- and 30-year Treasury bonds at a time when yields are very low and the Treasury is set to issue a record amount of debt. The pending supply deluge at the long end of the market has played a role in a steeper yield curve. In mid-December both the 10- and 30-year bond auctions met poor demand despite the yield curve reaching the historically steep levels witnessed only in 1992 and 2003. In other words, despite the added yield relative to short-term bonds, demand at both auctions suggested a steep yield curve alone may not be enough to help sell longer term bonds. Furthermore, T-bill issuance has declined on relative basis, helping to keep all short-term yields very low.
Fed officials continued message of lower for longer has kept short-term yields low as well. The Fed maintained use of the “extended period” language at the conclusion of the December 16 Federal Open Market Committee (FOMC) meeting and in public speaking engagements, Fed Chairman Bernanke and other voting members of the FOMC have made no mention of removing stimulus. The complete lack of action towards an exit strategy has helped keep short-term yields pinned low and the yield curve steep. In our view, the Fed will likely wait until the second half of 2010 to hike interest rates, slightly later than the consensus expectation. When this outlook for the Fed is combined with supply pressures, the yield curve is likely to remain relatively steep for most of 2010.
Investor implications
A steep yield curve bodes well for risk assets such as stocks and high yield bonds. Aside from the beneficial impacts to the economy, the steep yield curve usually results from low short-term yields and encourages investors to take risks. In Chart 3, we shift the yield curve forward by two years (since it is a leading indicator) to show the correlation to the equity rally of the 2000s. Note that this correlation is more of a recent phenomenon and evident only in the past decade. The well-known “carry trade” was made possible by steep yield curves globally and helped fuel this rally. Will the trend continue going forward? So far the S&P 500 has followed the trend and is following the yield curve higher albeit on a lagged basis. Anecdotal evidence suggests the carry trade is present again but on a much lesser scale. Whether stocks regain prior peaks is unknown but the steep yield curve, even if slightly steeper due to Treasury issuance needs suggests a tailwind is at the back of risk assets to start 2010.
Ultimately, the yield curve will flatten but we believe it will take Fed action to do so. With T-bill supply declining relative to longer-term notes and bonds, controlled inflation expectations, and benign comments from Fed officials, the yield curve will likely need concrete signs of a Fed rate hike before a flatter yield curve ensues. Such a move would pose a challenge for risk assets such as stocks and high yield bonds. We remain vigilant to a potential rate increase or even a significant change in language from the Fed but believe a relatively steep yield curve will persist for most of 2010.
IMPORTANT DISCLOSURES
- The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
- Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fi xed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
- The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
- High yield/junk bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors.
- International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
- Stock investing involves risk including loss of principal.
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