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 What
can the yield curve tells about future equity returns?
The past six months have seen spreads, a measure of the difference in
yield between two securities, contract from historically wide levels across
the fixed income market. Whether it is high yield, investment grade, LIBOR – spreads
have been tightening nearly everywhere one looks. Recently, however, one
measure of spread reached the widest levels of the past twenty years: the
Treasury yield curve.
When measuring the “spread” of the Treasury yield curve, one
compares the yield on longer dated Treasury securities with shorter-term
Treasury securities. (In this article we will focus on the difference between
the 10 Year Treasury and the 2 Year Treasury.) This “spread” tells
us about the slope of the Treasury yield curve. When the 10 Year is yielding
more than the 2 Year, is the yield curve is described as positively sloped,
or steep. However, when they are equal, the yield curve is flat, and when
the 10 Year is yielding less than the 2 Year, the yield curve will be inverted.
These terms are the conventional jargon used to describe the shape of the
yield curve.
Below is a graph depicting the various shapes of the Treasury yield curve:
The shape of the yield curve is a widely accepted leading indicator of
the economy. A steep yield curve is viewed as a positive for the economy;
financial institutions are encouraged to lend, as they can borrow at a
low short-term cost and then lend that money at a higher level, capturing
the spread. This increased lending, and hence investment, help to facilitate
economic growth.
On June 4, 2009 the difference between the 10 Year and the 2 Year was
2.76, resulting in the steepest yield curve in the past twenty years. While
this is a positive indicator for the economy, what, if anything, can the
yield curve indicate about future performance of the stock market?
The graph below, which plots the slope of the yield curve and the S&P
500 over the past ten years (ending 6/30/09), is a good starting place
in our search for an answer to this question. The graph suggests that there
is a negative relationship between the slope of the yield curve and the
S&P 500; in fact, the two have a correlation of -0.8 over this timeframe.
Over the past decade there has been an inverse relationship between the
yield curve and the stock market. But can the level of spread give us an
indication of future returns of the stock market? One way to answer this
question is to separate the data into quintiles based on the level of the
slope and examine future returns. As seen in the chart below, on average,
equities had the strongest performance over each timeframe following periods
when the yield curve was at its steepest. Over the three-year timeframe,
we see a pattern of descending average returns as the slope of the y-ield
curve decreases. This demonstrates that higher returns tended to follow
periods with steeper yield curves.
I have also included a simple breakout of times when the yield curve was
inverted versus times when it was positively sloped. This demonstrates
the market tended to perform poorly following times when the yield curve
was inverted, which is an observation we will return to again.
One aspect that we have not considered yet is the rate of change of the
slope of the yield curve. Is the yield curve becoming more steep, or
steepening? Or is it becoming less steep, or flattening? Here we are
looking to describe
how the shape of the yield curve is changing. Below is a look at comparing
times when the yield curve was steepening versus when it was flattening.
Over each timeframe, equities outperformed following periods of yield
curve flattening. 
So far, the data presented suggests that equities outperform following
periods of yield curve flattening, and underperform when the yield
curve is inverted. We can take this a step further and combine both
the shape
of the yield curve and the rate of change of the slope of the yield
curve, which would answer a question like: ‘does the market outperform when
a positively sloped yield curve is flattening?' Below is a
chart showing equity returns following the various combinations of
yield curve
shape and rate of change. From this analysis, it appears that the
effects of an inverted yield curve were more influential compared
to those of a
flattening or steepening yield curve.
After running through a number of scenarios and analysis, what does
today's
historically steep yield curve indicate for the stock market?
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First, we observe that the yield curve is positively sloped. This is
a positive as we have shown that the market tends to perform well following
periods with a positively sloped yield curve (and negatively
following an inverted yield curve).
- Second, that the slope of the yield curve is at an extremely steep level
is a positive for the market. Over the past ten years, the level
of steepness has been indicative of future equity returns. Strong stock market
returns
have tended to follow periods of maximum steepness.
- Third, the yield curve is coming off of a period of yield curve steepening.
This has been a negative signal for the market, as it tended
to underperform following periods of curve steepening.
While we should keep in mind that there is no guarantee that the past
will repeat itself and that relationships between factors can change over
time, the yield curve appears to be indicating strong future returns from
the stock market.
-- Jeff DeMaso, Research Analyst
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