Yield Curve Shifts: What They Mean for Investors
The U.S. Treasury yields and the changing shape of the Treasury yield curve are crucial indicators for investors, providing insights into the market's expectations for economic growth, inflation, and monetary policy. Recently, both short- and long-term yields have fallen, led by short-term maturities. This change has resulted in a bull steepening yield curve shift, a phenomenon that bond traders attribute to weakening economic conditions, moderating inflation, and the increasing likelihood that the Federal Reserve (Fed) will lower rates.
Understanding Yield Curves
Yield curves are crucial indicators that bond investors monitor closely. However, many stock investors overlook yield curves, despite their significant influence on stock returns. This two-part series aims to shed light on the four primary types of yield curve shifts and their implications from an economic and inflation perspective.
In the second part of this series, the focus will be on providing a quantitative perspective on what a continued bull steepening trade may mean for the returns of major stock indices, as well as various sectors and factors.
Treasury Yield Curve History
The graph below charts the ten- and two-year Treasury yields and the difference between these two securities, known as the 10-year/2-year yield curve. This yield curve has a recurring pattern that correlates well with the economic cycle.
Typically, the yield curve steepens rapidly following a recession, then flattens throughout most economic expansions. The yield curve often inverts towards the end of the expansion. One of the most accurate recession indicators is when an inverted yield curve steepens, returning it to positive territory. Finally, the yield curve rises rapidly as the Fed lowers rates to stimulate economic activity and combat a recession.
The Baby Bull Steepening
Recent weakening labor data and broader economic activity, coupled with moderating inflation, have convinced markets that the Fed will initiate a series of rate cuts starting in September. Jerome Powell, the Fed Chairman, has all but confirmed this in his Jackson Hole speech.
Bond yields have been falling, with shorter-term bond yields falling the most. The recent bond market rally has caused the yield curve to increase from negative 46 basis points in mid-June to negative single digits today. It is now on the verge of uninverting and consequently close to sending a recession warning.
This type of movement in long and short-term bond yields is commonly referred to as a bullish steepening. The terms "bull" or "bullish" relate to the fact that bond yields are falling, and consequently, bond prices are rising. "Steepening" refers to the shape of the yield curve, which has increased, although the current yield curve is still negative.
Four Principal Types of Yield Curve Shifts
To better understand yield curves, it's worth discussing the four principal types of yield curve shifts and what they often signify.
Bull Steepening
A bull or bullish steepening occurs when all Treasury yields decline, but shorter maturities fall more than longer maturities. This type of steepening often results from traders anticipating easier monetary policy due to pronounced economic weakness and a growing likelihood of recession.
Bear Steepening
In bear steepening, yields for short and long-term maturities increase, with longer-term yields rising more than shorter-term yields. This type of steepening occurred in 2020 and 2021 when the Fed lowered rates to zero and implemented massive amounts of quantitative easing (QE).
Bull Flattener
A bull flattener trade involves short and long-term-maturity bond yields declining, with longer-end yields falling more. Bull flattening shifts tend to be the result of relative economic optimism.
Bear Flattening
In a bear-flattening trade, yields rise across the curve, with shorter maturities rising the most.
Summary
With an understanding of yield curves, the focus can now shift to the implications of a bullish steepening trade for various stock indices, sectors, and factors. It's important to note that while the stock market often welcomes the idea of the Fed lowering rates, the actual lowering of rates doesn't always bode well for stock investors.
Bottom Line
Understanding the shifts in yield curves and their implications can be a valuable tool for investors. As the market anticipates a bullish steepening trade, it's crucial to consider what this could mean for different stock indices, sectors, and factors. However, it's also important to remember that while the prospect of the Fed lowering rates may be initially welcomed, the actual lowering of rates may not always be beneficial for stock investors. What are your thoughts on this matter? Feel free to share this article with your friends and discuss it with them. You can also sign up for the Daily Briefing, which is available every day at 6 pm.
