A Steepening of the US Treasury Yield Curve
A steepening of the US treasury yield curve is a positive sign of an improving economy. It often translates to a bullish stock market, strong corporate earnings, and under extreme conditions inflationary environment. On the other hand, a flattening of the yield curve warns of economic weakness and a possible recession in a worst-case scenario.
The sharp rise in US interest rates and the steepening of the yield curve are often favorable. It suggests the market expects an economic recovery. However, sharply higher yields and a very steep yield curve can also warn of an economy expanding too fast, which at extremes can lead to inflationary pressures.
The 3-month treasury yields are a benchmark for the short-end of US maturities. The 10-year yields are a proxy for the long-term US interest rates. The US treasury yield curve spread between the 3-months and the 10-year note yields is trading at the steepest levels since the 2013-2014 timeframe. The bond market may be pricing in future fiscal and monetary policies, the rollout of the Covid-19 vaccine, and the reopening of the economy. Under normal conditions, this tends to lead to a sustainable economic recovery. Under extreme conditions, this can lead to the risk of inflation.
The market does not appear to be pricing in higher debt levels from the massive stimulus spending programs. Instead, it is pricing in the economic benefits of the fiscal policies and the easy monetary policies. If the economy overheats, and the expectations of rising inflation begin to increase, then this could be negative for stocks as corporate earnings and profit margins come under pressure.
Typically, the yield curve does not often steepen with the long-end rates moving up far above the short-end rates. When this has occurred, it has led to a difficult period for the financial markets. Why? When the long-end rates rise too sharply in sustained moves, the FED becomes increasingly concerned about rising inflation. The FED will then signal that they are ready to cool an overheated economy by raising rates to prevent inflation from developing. The FED action will effectively begin to slow down the economy, resulting in a stock market peak.
Because of the pandemic, is this time around different? The Fed has stated that it would keep interest rates low for an extended period. Continue with its bond-buying programs and allow inflation to move in an average range that may exceed its 2% target without implementing a rate hike. Treasury secretary Yellen has also stated the US government should continue to roll out massive stimulus programs to help the economy recover. Will the above developments allow the US economy to continue to extend further, leading to higher stock prices resulting in the ever-elusive but an ominous speculative stock market bubble?
The question then becomes - when does the stock market begin to price in too high of an interest rate environment. A lot still depends on the extent, the sustainability of the rise in US interest rates, and most importantly, how steep the yield curve becomes. Our technical studies show the steepening of the US yield curve can be positive for the US economy. But it can also warn that too sharp of a rise in the long-term interest rates can steepen the US yield curve to an unsustainable extreme level which causes problems for the FED, government, and the financial markets.
In prior technical reports, we showed the inversion of the U.S. Treasury yield curve does not necessarily lead to an economic contraction or a major US recession. Rather, it is when the spreads of the 10-year yields and the 3-month yields contract to an extreme low (negative spreads) and begin to rapidly steepen that this leads to either a deep economic contraction or worse, a recession. Since the stock market is a leading indicator of US business cycles, the stock market peaks and enters a bear market.
For instance, when the yield curve traded to an extreme low of -0.95 on January 2000, it would soon reverse direction and expand sharply higher. The steepening of the yield curve subsequently led to the Tech/telecom dot.com bubble burst and the 2000-2002 stock market bear.
Once again, ahead of the global financial crisis, the yield curve spread contracted to an extreme low of -0.64 in February 2007 before suddenly reversing direction and expanding sharply higher. It ultimately led to the global financial crisis/recession and the 2007-2009 stock market bear.
As we fast forward to 2019, the US yield curve again plummeted to an extreme low of -0.52% in August 2019, rebounding near the pivotal 2007 bottom (-0.64 spread). The yield curve bottoms and began to steepen.
Last year (2020), the yield curve spread (1.50) cleared above two major long-term moving averages, the 10-mo and 30-mo ma (0.76/0.38), thereby confirming a monthly golden cross buy signal. The technical development further confirms the steepening of the yield curve. Also, the breakout above the 2014 downtrend (0.92-0.93) and a higher-high pattern above 1.16 (March 2020 reaction high) further reaffirms the steepening of the yield curve. The next key resistance is 1.63-1.66, or the crucial 61.8% retracement from 2014-2019 decline and Jan 2017 low). Will a convincing breakout here send the yield curve back to retest the extreme highs of 3.83-3.87 (1992/2004/2008/2010 highs)? Or will the failure to surpass 1.63-166 signal the next contraction in the yield curve?
In summary, in the three prior periods of steepening of the yield curves, two occurrences led to extreme steepening of the yield curves resulting in recessions and SPX bear declines (i.e., 2000-2002 and 2007-2009). However, the third occurrence (2013-2014) resulted in a modest steepening of the yield curve neither triggering a recession nor an SPX bear decline. Will we repeat the former or the latter?