What Does a Flattening Yield Curve Mean for Bonds, the Economy and Stocks
In the last couple of weeks or so, US treasury yield curves have begun to flatten. That may sound unduly technical and boring, but it has implications for bonds stocks and the economy. I'll get to the investment implications later, but for now I'll quickly through run through the dry stuff for those unfamiliar with the yield curve concept.
A yield curve is a spread between a long maturity and a short one of a similar quality issuer. An example of one of the most popular spreads, that between the 10-year and 2-year Treasury, is featured in Chart 1. When it is in a rising mode, that means that the yield on the 2-year is underperforming that of the 10-year. "Underperforming" usually means that both are declining due to an easy money policy, but the 2-year is dropping at a faster rate. This process is known as "steepening" because the spread between them is widening. When short rates gain on long ones, the curve is said to be "flattening" because the spread is narrowing.
When the curve starts to flatten, it means that monetary policy has become less accommodative, but not to the extent of an actual tightening. In the case of Chart 1, tightening is signaled when the 2-year approaches or exceeds its 10-year counterpart, a process known as inversion. Inversion is unusual, but typically signals a recession is on the horizon. Only the timing is in question. So, to summarize, a steepening curve indicates easy money, while flattening means less easy initially until the curve approaches inversion, in which case it reflects a tightening.
Fast forward to the current situation and we can see that the curve has most likely begun a flattening path, as evidenced by the fact that it has crossed decisively below its 12-month MA and seen a peak in the 12-,18- and 48-month ROCs.
What Effect Does a Flattening Curve Have on Bonds
Now that a technical case for a new a new flattening trend has been made, its time to ask the question - What does this means for stocks and bonds? The bottom window in Chart 3 displays the yield curve in the bottom panel, together with the 10-year yield in the upper and 2-year in the middle ones. The green vertical lines approximate the demarcation point between a steepening and flattening processes. The red and green arrows tell us what typically happens after this point. There is no hard and fast rule, but, generally speaking, the 10-year series initially softens (as flagged by the red arrows) and then firms up. In the case of the 2011 and 2014 examples, this softening followed a firming, as, in this market (as opposed to Fed-driven), maturity had already begun to discount the forthcoming rise in the 2-year. That's not unlike the situation this this time around, where the steep August 2020-March 2021 jump in the 10-year yield anticipated the hike in short-term rates that has just taken place.
On the other hand, the two-year, which leads money market rates, consistently turns up once the curve begins its flattening process.
In that respect, Chart 4 shows that the 2-year series has recently broken out of a significant base, a development that is supported by all three KSTs. The short-term series is getting overextended, so we may see a digestion of gains in the period directly ahead. However, the breakout is certainly consistent with the historical experience of a firming of short-term rates following the start of the flattening process. The outlook for the yields on longer-term maturities likely involves some softening or rangebound activity, to be later followed by a firming.
The Message for the Economy
Chart 5 compares the curve to nonfarm payrolls, a coincident economic indicator. The arrows connect yield curve peaks to cyclical highs in the nonfarm numbers. Softness in this indicator typically signals the onset of a recession. The fact that the arrows slant to the right tells us that there is normally a long lead time between the point when the curve starts to flatten and employment suffers. In one case, that between the double dip recessions of 1980 and 1982, there was not much of a lead time. In most, though, it has been of a multi-year duration. We don't know how long the current lead will be, but, until the curve comes close to inversion, it is giving us the all-clear. Please note that, due to a lag in reporting the nonfarm numbers, this chart has only been plotted up to May and does not include the June yield curve reversal shown in the other charts.
The Start of the Flattening Process is Good News for Equities
The start of the flattening process tells us that the economy has reached the stage where it does not need help from the central bank and is self-sustaining; escape velocity, if you will. That's good news for the stock market, which loves a growing economy. In that respect, the vertical lines and arrows in Chart 6 show that a flattening in the curve is typically followed by a long-term bull market. That certainly does not rule out the odd 5-10% correction along the way, but the firming economy provides a positive overall long-term backdrop. Since the curve has only just begun to flatten, the message for equities is clearly a bullish one.
Good luck and good charting,
Martin J. Pring
The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Groupof Walnut Creek or its affiliates.
