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March 2019

What the yield curve can tell equity investors

Christopher Dhanraj
Director
Head of iShares Investment Strategy

Key points

  • With the U.S. Treasury curve at its flattest level in the post-crisis era, upcoming economic data releases should be critical in assessing the trajectory of the yield curve in 2019.
  • Investors historically view the shape of the yield curve as a signal of future economic growth. We do not believe the current yield curve is signaling a recession, but rather that it reflects the Federal Reserve's interest rate hikes and decelerating economic growth.
  • Against this backdrop, the iShares Investment Strategy team documents the historical relationship of equities to different yield curve regimes over the last 20 years.

The yield curve: An explanation

A yield curve plots the interest rates of bonds with equal credit quality at different maturities. Given the size and importance of U.S. Treasuries, the U.S. Treasury yield curve in particular is closely monitored by both domestic and global investors.

The slope of the yield curve is quantified by taking the spread between interest rates at different maturities. A conventional measure of the curve is the spread between yields on two- and 10-year bonds. 10-year yields historically have reflected the market’s growth and inflation outlook, while the short end of the curve is mainly tied to market expectations for Federal Reserve policy rates.

What the yield curve can tell us

Investors have historically viewed the shape of the yield curve as a signal of future economic growth. It is typically the steepest after recessions, as the Federal Reserve lowers the federal funds rate to stimulate economic activity, and flattens over the course of the business cycle as the Federal Reserve raises the federal funds rate to contain inflation, lifting short-term rates in the process. If a recession looms, the yield curve typically becomes “inverted,” when two-year yields are higher than 10-year yields. In the post WWII era, the yield curve has inverted before every recession.

Figure 1: A historical look at 2s10s spread and recessions

Figure 1: A historical look at 2s10s spread and recessions

Source: Thomson Reuters, NBER. As of February 22, 2019. Notes: Shaded gray bars denote NBER defined U.S. Recessions. The U.S. 2s10s spread is the difference in yields between the 10yr and 2yr U.S. Treasuries. The 2s10s spread is a common measure of the slope of the yield curve. When the spread is above 0, the 2s10s spread is upward sloping, at 0, it is flat, and inverted when it is below 0.

The shape of the yield curve depends on a number of factors; for example, it could flatten due to falling long-term yields and/or through rising short-term yields. We believe investors may benefit from a full understanding of both the level of yields and the slope of the yield curve. In general, then, we can decompose the yield curve into four basic regimes:

  • Bear steepening – interest rates rising, yield curve steeper
  • Bear flattening – interest rates rising, yield curve flat
  • Bull steepening – interest rates falling, yield curve steeper
  • Bull flattening – interest rates falling, yield curve flat

The chart below illustrates when those four regimes prevailed as the yield curve changed over the last 40 years:

Figure 2: The U.S. yield curve through different regimes

Figure 2: The U.S. yield curve through different regimes

Source: Thomson Reuters, NBER, as of February 22, 2019. Notes: Shaded gray bars denote NBER defined U.S. recessions. The solid blue line is the 2s/10s U.S. yield curve. The four yield curve regimes are defined over a trailing six month window.

Figure 2 also identifies how the curve gradually flattened from 2014 to 2019 to levels not experienced since the financial crisis. Several factors influenced this trend on both the front and long ends of the curve. At the front end, the Federal Reserve’s removal of crisis level stimulus – in the form of nine Federal funds rate hikes since 2015 and its balance sheet normalization program – plus high levels of debt issuance pushed short-term rates to post-crisis highs. At 2.5%, the two-year yield is currently 2.5 times its 2008 – 2019 average. At the long end, fears over deteriorating economic conditions and uncertainty over the direction of Fed policy drove long-term yields lower.

The yield curve and equities

As noted, the yield curve has historically been an effective real-time business cycle indicator. However, we find that incorporating the changing level of interest rates into an analysis of the yield curve provides important insights beyond what just the slope of the yield curve can tell us.

Over the course of the business cycle, equity market leadership often rotates amid changing economic fundamentals. We document the historical relationship over the last 20 years as it relates to the changing level of interest rates and the yield curve shape. Unsurprisingly, there is a significant dispersion across regimes for both the broad market and relative sector returns.

Figure 3: Distribution across yield curve regimes

Figure 3: Distribution across yield curve regimes

Source: Thomson Reuters, as of February 22, 2019. Data covers 150 S&P 500 subsectors since 1995. Average returns are measured over 6 months for consistency with the lookback window to classify yield curve regimes. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance is no indication of future results.

As the table shows, equities have performed best during the Bear Steepener regime. It is the best “risk-on” environment, typically capturing increasing bullish sentiment via rising interest rates and stronger conviction around the growth and inflation outlook as long-term rates rise by more than short-term rates.

Meanwhile, the Bull Steepener is the worst risk-on regime. This regime largely reflects the Federal Reserve easing monetary policy in response to a recession. However, our research shows that 25% of the S&P 500 subsectors showed positive six-month average returns during these periods, highlighting the defensive nature of select sectors and the importance of sector rotation over the course of the business cycle.

In short, yield curve regimes matter for overall market returns, but they also affect relative sector returns.

The broad market return (as measured by the S&P 500 Index) has its best returns in bear steepening periods, which occur in reflationary regimes and are often found early in the business cycle when the economy emerges from recession. In risk-on regimes, cyclical sectors (i.e. consumer discretionary, financials, industrials) historically have performed the best. In risk-off regimes, defensive sectors historically have performed the best, e.g., consumer staples, health care.

Conclusion

The yield curve is a valuable real-time business cycle indicator, but it can be improved by incorporating the changing level of interest rates into the analysis. By doing so, investors may be able to identify sectors and sub-sectors that are most likely to outperform the broader market.