Interest rates have been in the spotlight since last week, with the 10-year Treasury yield touching 3% in more than four years. Investors are also getting worried about the potential flattening of the yield curve.
The 10-year Treasury yield rose to 3% yesterday followed by a negative reaction from the stock market. Investors are getting wary of equity investments as fixed income yields continue to rise; the S&P 500 fell 1.35% during yesterday’s trading. In other news, Treasuries spread between five to 30 years hit the lowest in more than a decade. Negative spread has been associated with the onset of recession, which is making investors anxious.
Although there is much concern around flattening of the yield curve, the inversion – that refers to higher short-term rates compared to long-term rates – is not imminent. Moreover, equity investors should be worried about the shift up in the yield, not the yield curve.
Yield spread has been a precise indictor of downturns.
The gap between the two-year yield and the 10-year yield was negative or hovering around zero in all of the last three major downturns in the market. Just before the correction of early 1990s, interest rate on the two-year Treasury bills was 50 basis points higher than 10-year rates. The same was the case before the crisis of the early 2000s. Before the downturn of 2008, there was no difference between the yield of the two-year and 10-year Treasury bonds. In short, the reduction in yield differential – otherwise termed as the flattening of yield curve – is a vital indicator when it comes to predicting the direction of the market.
Equal yields means flat curve is a major misconception
Flattening of the yield curve refers to the scenario when the yield of long-term fixed income assets starts to move downwards to close the gap between short-term and long-term yields, or vice versa. The yield curve is flat when short-term instruments can be used to exactly replicate the return of a long-term, fixed-income instrument. This is in contrast to the misconception that yield curve is flat when there’s “no yield spread” between short-term and long-term yields. The yield curve is already inverted when that happens.
We’re not there yet!
First things first: The yield curve isn’t flat. The increase in yields has been uniform across all maturities during 2018.
Although the curve is not steep, the yields across maturities have been rising uniformly since the start of 2018.
Focus Equity Estimates, based on the data from U.S. Department of Treasury
Notes to Table: Yield curve capturing maturities ranging from one month to 30 years. The color-coded gradient shows the rate of change in yields between different maturities.
What is important to note is that the graph is fatter in the middle and slim towards both ends. This indicates that yields have been rising at a higher rate for the 10-year and 20-year maturity instruments, which debunks the whole idea of yield inversion.
Moreover, yields are now more sensitive to changes in maturities. It can be seen in the graph that a jump to the next available maturity instrument will bump the yield by 15.3 basis points now as compared to 14.8 basis points in January 2018. This is indicative of the fact that long-term yields have been responding to increases in short-term interest rates.
Yield curve inversion isn’t in the cards, at least for now
For starters, yield curve of today shouldn’t be compared to the curve of pre quantitative easing era. Central banks were not artificially suppressing yields at that time as opposed to now. The Fed’s aggressive purchase of long-term fixed-income securities narrowed the spread between the short-term and the long-term yields. Consequently, central banks, specifically the Federal Reserve, now have the tools to contain the flattening of the yield curve.
The Fed’s balance sheet normalization counters yield inversion
Simply put, as the Fed continues to dump long-term fixed income securities in the open market, long-term yields will get a boost, which will protect the yield curve from inverting. The Wall Street Journal reported, “UBS argues global quantitative easing has distorted long-term bond yields by reducing the term premium, or the extra yield investors demand for uncertainty about monetary policy.”
Oh, the irony!
Ironically, the yield flattening tantrum is exactly what can actually stop the yield curve from flattening. If investors fear a downturn, they will move the money to safe assets such as commodities, which can decrease the demand for long-term bonds. This kind of scenario will curb bond prices supporting yield increases.
Rising interest rates, not the flattening of yield curve, should be a cause of worry for equity investors
The problem for the equity market doesn’t lie in the so-called flattening of the yield curve. For those of you worried about the yield curve for other reasons, it’s not going to happen any time soon. Anyhow, the problem for the stock market actually lies in the rising interest rate environment, which will make investors move their money toward fixed-income securities, marking an end to the decade-long bull rally.
Short-term rates are rising. Long-term rates will follow suit amid the roll back of quantitative easing and increased demand for short-term fixed-income assets. The point is whether or not rising rates put a stop to economic growth. They will certainly put the brakes on the equity market returns.
