This blog has tended to focus on “risky” asset classes, meaning assets whose price is not strictly tied to the current yield that they offer, largely because, unlike bonds, they offer potential for increased cash flow or underlying principal value over time. Part of the reason that Market Compass has stayed away from bonds is that they are, at least superficially, less interesting – they offer lower returns under most interest rate scenarios, apparently little upside potential, and seemingly little inflation protection. The other reason, though, is that in some sense, in working with bonds from a macro perspective, we don’t have the sample sizes that we have with risky assets. Stocks, REITs, commodities and other risky assets go up and down in value with enough frequency that we can observe multiple, independent episodes and draw statistical conclusions about their behaviour. At the broadest macro level, bonds in the last 5 decades offer us really 2 situations: yields rising at an accelerating pace from 1962 through 1980, and then falling from 1980 through at least 2012. Figure 1 shows the yield on the 10-year US Treasury, which is one of the key benchmarks for interest rates globally:
Figure 1. 10-Year US Treasury Yields, 1962-2013
Data source: Yahoo! Finance
So unlike stocks, which have offered multiple bull and bear markets in this period, bonds really offer a sample size of 2 for major trend moves.
However, we can see that yields have tended to bounce around their trend. More importantly, bond yields have the important characteristic of being related across what is called the “yield curve.” Bonds of similar maturity are close substitutes for one another – if a 10-year bond has a certain yield, an investor will expect a similar yield from a bond maturing in 9 or 11 years, after making some allowance for the slight difference in maturity (and for other factors such as credit quality, which we will ignore here as we are dealing with US treasuries which, debt ceiling and budget shenanigans aside, are generally viewed as “riskless” from a credit perspective). In general, yields will be a little higher for bonds of longer maturity, as investors expect a bit of compensation for the added uncertainty and higher volatility of longer-dated bonds. The result is that if interest rates are plotted against time to maturity, they typically (although not always) form an upward-sloping line, known as the yield curve:
Figure 2. Current US Treasury Yield Curve
Data source: wsj.com
As we can see, the current US Treasury curve is fairly flat out to 1 year, and then rises to roughly 3% at the 10 year mark. This 3% level for the 10-year represents a rise of over 1% off recent lows, but is still quite low by historical standards, as we can see from Figure 1.
If we compare the 10-year yield to the 3-month treasury-bill yield, we can get a quantitative measure of the “steepness” of the yield curve. If we plot this over time, we can see that the current level of roughly 300 basis points (3%) is towards the high end of the historical range:
Figure 3. Yield Curve Steepness: 10-Year Treasury Yield Compared to 13-Week Treasury Bills
Visually, it looks like the current level of curve steepness is one that can be maintained for some time – it looks like the yield curve flattens periodically (steepness declines to 0, or even below) and then it springs back to the point where the 10-year yield is 200-300 basis points above the 13-week T-bill yield. These periods of 200-300 basis point steepness appear to last up to 8 years or so (allowing for some fluctuation), so it does seem that it’s safe to describe this level of steepness as “normal” in some sense.
If we look at what this kind of steepness implies for interest rates, we can see that there is some tendency for the yield curve to tend towards an average steepness of about 100 basis points over time – ie, when it is less steep than this, it has tended to increase, and vice versa:
Figure 4. 12-Month Change in Steepness of Yield Curve, Given Starting Level of 10-Year – 13-Week Steepness
As we can see, from very low (or negative) levels of steepness, there is a tendency for the yield curve to steepen; while from steep levels (over 100 bps) there is some tendency for the yield curve to flatten.
If we break down the change in steepness based on whether it is driven by the “short end” or “long end” of the curve, we can see that this varies based on whether the curve is steep or flat. When the curve is flat or inverted, it tends to be a fall in short-term rates that leads to steepening; conversely, when the curve is steep, long rates tend to fall. This is consistent with the general view that a flat or inverted curve tends to be reflective of periods when economic conditions are weakening, and when traditionally the Fed has stepped in to lower short-term rates. Conversely, a steep curve is taken to reflect economic strength, and flattens as cyclical effects pull it down.
Figure 5. 12-Month Change in 10-Year and 13-Week Rates, Given Starting Level of Curve Steepness
We can see this dynamic at work if we plot recessions (as defined by the US National Bureau of Economic Research) on the chart that we looked at earlier:
Figure 6. US Rates, Curve Steepness and Recessions
Data sources: Yahoo! FInance, NBER
The chart shows that the yield curve tends to be flat to inverted immediately prior to recessions (the purple bars) and that it tends to steepen substantially during the recession, as short-term rates (the red line) fall in response to Fed actions. During periods of economic expansion, steepness tends to be driven initially by the longer end of the curve, which will remain high until tightening by the Fed (seen in the rising red line) leads to flattening – and eventually to recession and renewal of the cycle.
Given today’s level of steepness of around 300 basis points, history would suggest that on average we would expect some flattening over the next 12 months. However, given the unusual dynamics of quantitative easing and the Fed’s repeated promises to stay “lower for longer,” it might be worth holding off on any large macro trades based on this insight. In terms of implications for risky assets, we can see that a steep yield curve has been a moderate positive for stocks:
Figure 7. Average 6-Month Forward Performance for S&P 500, Based on Starting Level of Curve Steepness
I say “mildly” positive because while it appears that returns are positive when steepness is positive, and negative for a mildly inverted yield curve, these averages are swamped by the range of outcomes, with standard deviations of over 10% in some cases around these averages.
If there are any actionable implications in this review of yield curve steepness, they might come from looking at some of the sectors that have recently been impacted by rising rates. This analysis suggests that there is some tendency for the yield curve to tend towards a flatter level than where it is now, which could help REITs, utilities and other dividend-focused sectors (which have lagged in the face of recent interest rate rises) in the coming year. It could also weigh a bit on the recent rally in financials (which “borrow short and lend long,” and thus tend to thrive under a steeper yield curve.) There is no requirement for the curve to flatten, but the odds would appear to favor some amount of flattening over further steepening.
All that being said, the Market Compass models continue to operate without these kinds of subjective inputs, and their current outputs can be found in the usual place.
Have a good week and a Happy New Year!