What is the yield curve telling advisers and clients?

No investment indicator is infallible – if it were, none of us would be working and all of us would be playing the markets (only to find, ultimately, that there would be nothing in which to invest except each other’s investments).

“The curve in the UK stands at its steepest since August 2019, while in the US, the yield premium offered by ten-year US Treasuries relative to two-year paper is at its highest since October 2017.”

However, one which is generally held to stand the test of time is the yield curve, so advisers and clients may be intrigued to learn that the curve in the UK stands at its steepest since August 2019, while in the US, the yield premium offered by ten-year US Treasuries relative to two-year paper is at its highest since October 2017.

In theory, this is the bond markets’ way of saying that an economic upturn, and possibly inflation, are coming. This is a view which has considerable implications for financial markets and asset allocation strategies overall, as well as fund and specific stock selection strategies.

Big switch

In general terms, there are four types of yield curve, using the difference in yield between two- and ten-year Government bonds as a benchmark.

• Normal. Here, yield on the ten-year paper is higher than that of the two-year. Advisers and clients demand compensation for the additional eight years to maturity, as this means there is more time for things to go wrong, with inflation, interest rate increases or default being the main three dangers.
• Steep. In this case, long-term yields rise more quickly than near-term ones as investors look to price in an acceleration in economic growth and interest rate increases. Advisers and clients fear being locked into low rates and demand greater compensation for owning longer-dated paper.
• Flat. This is where the bond market is unsure how to proceed. Yields on two- and ten-year paper are the same as the economy transitions from downturn to upturn or upturn to downturn.
• Inverted. Here, bond markets fear an economic slowdown or recession and the yield on longer-dated bonds drops below that of shorter-term papers. This happens because advisers and clients price in future interest rate cuts in response to the slowdown and a drop in coupons on bonds issued by Governments in the future.

12-to-18 months ago, all of the talk was of how yield curves were inverting and how that could have been warning of trouble ahead (though no-one would pretend that fixed-income markets saw the pandemic or subsequent recession coming).

“The yield curve is now steepening in the US, a trend which characterised the early stages of the bull equity markets that began in 1982, 1990, 2002 and 2009.”

The picture is quite different now. Buoyed by further momentum, the race for a COVID-19 vaccine and further fiscal stimulus from Congress, combined with further monetary largesse from the US Federal Reserve, the yield curve is now steepening in the US, a trend which characterised the early stages of the bull equity markets that began in 1982, 1990, 2002 and 2009.

The yield curve stands at its steepest in over three years



Source: Refinitiv data

Admittedly, Japan’s experiences since 1990 suggest the yield curve can be a poor predictor of economic activity but the yield curve has had its uses in the UK. Inverted yield curves in 2000 and 2007 helped to call the top for the FTSE All-Share index but a clear steepening marked the beginning of bull runs in 1998, 2003 and in the early stages of the last decade.

The UK yield curve is also steepening



Source: Refinitiv data

Style council

There may be further implications below the level of headline indices. Banking stocks, for example, have been crushed by central banks’ efforts to keep yields low (and, by implication, yield curves flat) as they try to help governments fund their burgeoning debts. A steeper curve could boost banks’ net interest margins, earnings power, share prices and ability to pay dividends. This could be influential in the UK market, for example, where the FTSE 100’s Big Five banks are so integral to earnings and dividend growth forecasts.

Banking stocks could well benefit from a steeper yield curve



Source: Refinitiv data

“A steeper yield curve, hinting as it does at a stronger economy and inflation, seems to favour cyclical earnings growth over secular earnings growth – or, to put it more crudely, ‘value’ as a style over ‘growth’ – at least if history is any guide.”

Even more intriguingly, a steeper yield curve, hinting as it does at a stronger economy and inflation, seems to favour cyclical earnings growth over secular earnings growth – or, to put it more crudely, ‘value’ as a style over ‘growth’ – at least if history is any guide.

As this column has noted (30 October 2020), value has tried to forge a recovery relative to growth, using the ratio of the price of the Invesco QQQ Trust, an exchange-traded fund (ETF) designed to track and deliver the performance of the heavyweight NASDAQ 100 index (minus its running costs), relative to the iShares Russell 2000 Value ETF, as a benchmark.

‘Value’ seems to be taking its lead from a steeper curve too



Source: Refinitiv data

Some are wondering if this trade is already exhausted. Looking back at 2000, you could argue that it has hardly begun, such was the violence of the switch from growth to value as the former began to falter under the twin weights of lofty valuations and earnings disappointment.

Russ Mould, AJ Bell Investment Director.