Trouble With the Curve

Let’s get one thing straight: Interest rates are still incredibly low. At a mere 1.6%, the rate of interest on a U.S. Government 10-year bond is still a fraction of the 15% yield offered in the early 1980s. Nonetheless, that 1.6% is already 100 basis points higher than the low set on August 4th last year. And while such an increase is hardly unprecedented, the pace, coupled with the backdrop of a Federal Reserve that has offered no indication of raising its target for the benchmark overnight rate, is far from ordinary. As a result, term spreads have widened significantly since last summer.

The difference between yields on 10-year and 2-year Treasuries, charted below, is now at the widest level since 2015 and shows little sign of slowing its ascent. Though in the middle of its long-term range, one more year like the last and spreads would match the highest levels of the last half-century.

The yield curve has steepened more dramatically in the last 6 months, at a rate not seen since the financial crisis more than a decade ago. And a rapidly steepening curve has tended to precede below average equity returns.

Using z-scores to normalize the interest rate data, I compared 6-month changes in the ’10s minus 2s’ yield spread, to ensuing changes in the S&P 500. The results were significant:

A steepening curve (higher z-score) tends to precede below average returns, while a flattening curve (lower z-score) is generally followed by above average returns. The relationship is most clear at extremes – when yield spreads rise too far, too fast, future returns are often negative.

The current z-score is above 2, sending a cautionary message to stock market bulls. No indicator is perfect, though, and we need to be aware of outliers. The chart below overlays the S&P 500 Index with periods where the z-score exceeds 1.5.

The spread indicator was most effective during the dotcom and housing selloffs, and again proved reliable in 2011. Signaling caution before each of those declines gives this indicator its merit. The record was more mixed in the early 90s, with a warning arriving too late to protect from the period’s largest selloff, but then providing adequate caution against below-average returns in the following years. On the other hand, poor results were achieved if investors blindly followed the indicator in 1985, 2009, or 2013, when equities turned in strong gains. Indeed, this indicator is not infallible.

With equity indexes at all-time highs, two of the most recent occurrences stand in stark contrast: 2008 and 2013. What will it be this time? Are stocks headed for pain, or is this a false alarm we can safely ignore?

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.

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