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Market View

Those who believe a flattening U.S. Treasury curve signals weakness in stocks may not be seeing the complete picture.  

[This Market View is adapted, in part, from a forthcoming whitepaper. This is the first of two parts.]

Should investors in U.S. equities fret about a flattening U.S. yield curve? The subject has been much on the mind of market observers. Indeed, as a recent Bloomberg investment blog noted, “Do flat times in the bond market always mean the same for stocks? That's the latest question testing the bull market.”1

To achieve a better understanding of the situation, we believe investors should have a more nuanced view of the yield curve and its relationship to economic growth, corporate profits, and, ultimately, U.S. equity prices. We turned to Giulio Martini, Lord Abbett Partner and Director of Strategic Asset Allocation, for his insights on the topic in this special two-part Market View.

As Chart 1 shows, the slope of the U.S. Treasury yield curve between the two-year and 10-year maturities has flattened by 74 basis points (bps) since early December 2016, and by 34 bps from a more recent peak on July 11, 2017. As Martini notes, the curve has not been this flat since September 2007.

 

Chart 1. Where It’s Flat: The U.S. Treasury Yield Curve
U.S. Treasury two-year–10-year yield curve slope, January 4, 2016–November 8, 2017

Source: Bloomberg.
Performance quoted above is historical. Past performance is not a reliable indicator or guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.

 

What would cause market participants to worry about this state of affairs? Martini says that many investors interpret a flat, or flattening, yield curve as a danger signal for stocks and other risk assets. That’s because a flat two-year–10-year yield curve could suggest an expectation of falling short-term interest rates, or an extended period of very low short-term rates.

“If the U.S. Federal Reserve [Fed] manages monetary policy counter-cyclically, then the expectation of falling short-term rates corresponds to the expectation of a weak economy and disappointing corporate earnings,” says Martini. Those are conditions that often prefigure a softer U.S. equity market. If market expectations are correct, then, on average, the yield curve should flatten before the economy weakens and the Fed starts easing, making the slope of the yield curve a leading indicator.

But Martini points out that there’s a potential flaw with this view, which is that a flattening yield curve doesn’t always mean that expectations for future short rates are being revised downward. What’s important to understand here, says Martini, is that market yield has two distinct components:

Market yield = Risk-neutral yield (current expectations for future short-term rates) + term premium (uncertainty around those expectations)

Martini calls the term premium “a catch-all” for market uncertainty regarding the expected path of future rates. (He discussed the significance of the term premium in terms of assessing potential moves in asset prices in a recent Economic Insights.) He says the uncertainty relates to future Fed policy, inflation, liquidity conditions, and other factors.

As it turns out, the majority of the recent flattening of the yield curve is estimated to have been due to a decline in the term premium (i.e., reduced uncertainty regarding the future path of interest rates) rather than a decline in expectations themselves. (See Table 1.)

 

Table 1. What’s Really Causing the U.S. Yield Curve to Flatten?
Breakdown of change in the two-year–10-year U.S. Treasury curve slope (ACM decomposition*) for the indicated periods

Source: Lord Abbett.
*Refers to historical decompositions of U.S. Treasury yields developed by economists Tobias Adrian, Richard Crump, and Emanuel Moench [collectively “ACM”] of the U.S. Federal Reserve Bank of New York.
Performance quoted above is historical. Past performance is not a reliable indicator or guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.

 

But many market observers, we believe, continue to hold onto an outmoded, unitary view of the relationship of the linkage between the slope of the yield curve, GDP growth, and the stock market. “A flattening of the yield curve due to declining relative long-term uncertainty should have very different implications for expected U.S. GDP growth than a decline due to falling expectations about future short rates,” Martini says. What about stocks? As we’ll explore in greater detail next week, while a reduction in forward interest rate expectations has potentially negative implications for equities, a reduction in the term premium has not historically been associated with stock market declines.

 

1Stephen Gandel, “Bond Investors Are Stock Investors’ Latest Concern,” Bloomberg, November 9, 2017.

 

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