The yield curve showing the difference between the 10-year and 3-month US Treasury yields spread (1.48) suddenly contracted today to levels last witnessed earlier in the month. The long-dated yields declined, and the shorter ones were flat-to-up today. The moves come just a week before the next FOMC meeting. Many expect the FED to announce the tapering of the $120 billion in monthly asset purchases and the timing of interest rate hikes next year.
The bond and stock markets faltered into the end of the day as investors have become concerned whether the US and other developed economies can handle higher interest rates to offset continued rising inflation caused by the bottleneck in the supply chain and the pent-up demand from the pandemic. Global yield curves have flattened today due to the long-term yields either falling faster relative to the shorter-term rates or not climbing as fast, amid concerns about global central banks lowering the amount of stimulus in the economy.
Flattening yield curves can also warn the economies are losing their momentum and heading toward a recession. The fear is the Fed and other central banks make policy mistakes with the restrictive monetary policies resulting in the end to the economic recovery.
Is the recent yield curve flattening sustainable, or is this temporary?
Ideally, investors like to see the steepening of the treasury yield curve as it is a sign of an improving economy. It often translates to a bullish stock market outlook, strong corporate earnings, and under extreme conditions, an inflationary environment. The gradual rise in interest rates and the steepening of the yield curve is ideal. It suggests the market expects a sustainable economic recovery. However, sharply higher yields and an extremely steep yield curve can also imply the economy is expanding too fast, creating inflationary pressures.
Our technical studies suggest the 3-month treasury yields remain the best benchmark for the short-end of US maturities. The 10-year yields are the best proxy for long-term US interest rates. Despite the recent sharp and abrupt yield curve contraction, the 10-year minus 3-month yield spreads retain their bullish 4-year cup and handle pattern.
The bond market may be pricing in a Fed taper next week. But the bullish accumulation type pattern remains intact, and if the yield spreads expand this can lead to the resumption of the current economic recovery. Under extreme conditions, a very steep and prolonged yield curve can lead to hyperinflation. When the economy overheats and the expectations of rising inflation sustain, 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. The FED needs to be careful not to be too restrictive as they can kill the economic recovery.
The pertinent question remains - 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 has been 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 and blogs, we have mentioned the inversion of the U.S. Treasury yield curve does not necessarily lead to an economic contraction or a major US recession. 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 a deep contraction or a recession.
Remember the stock market is a leading indicator of US business cycles, the stock market often peaks ahead of an economic top and bottom ahead of the end to a business contraction.
Let us review the prior US yield curve expansions and contractions.
Dot.com Debacle – The yield curve traded to an extreme low of -0.95 on January 2000. It would soon reverse its direction and expand higher. The steepening of the yield curve subsequently led to the Tech/telecom dot.com bubble burst and the 2000-2002 stock market bear market.
Global Financial Crisis – Once again, just before the onset 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 will also trigger the 2007-2009 stock market bear market.
Covid-19 Pandemic – 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 steepen.
Last year (2020), the yield curve spread (1.48) cleared above two major long-term moving averages, the 10-mo and 30-mo ma (currently at 1.42 and 0.66), thereby confirming a monthly golden cross buy signal. The technical development further confirms the steepening of the yield curve. 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 recent rally to 1.73 (Mar 2021) is close to confirming another key resistance at 1.64-1.66, or the crucial 61.8% retracement from 2014-2019 decline and the Jan 2017 low.
Will a convincing breakout here send the yield curve back to retest 2.97 (Dec 2013 reaction high), and above this to the extreme highs of 3.83-3.87 (1992/2004/2008/2010 highs)? Or will the failure to surpass 1.64-1.66/1.73 signal the next contraction in the yield curve?
In summary, in three prior occurrences of steepening of the yield curves, two led to extreme steepening, 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?