July 13, 2018— The slope of the yield curve has continued its relentless slide this month, with the yield differential between a 10-year and a 2-year Treasury bond falling below 0.27%. The closer this figure gets to zero, the more suspect investors become about whether the economy can withstand higher interest rates from the Fed. Historically, an aggressive Fed coupled with investors’ tepid future growth outlook has led to the yield on a 2-year Treasury exceeding that of the 10-year—resulting in what is known as an “inverted” yield curve. In this month’s Capital Perspectives, our In Focus outlined why we are cautious but not overly concerned about the yield curve.
One of the reasons for our outlook is that, while the yield curve has inverted prior to each of the last five recessions (the last seven if you look at the difference between a 10-year and 3-month Treasury yield), at surface level it has been a very poor timing tool. An inverted yield curve has led the pre-recession peak in equity markets by anywhere from 7 to 27 months. This represents a wide time range and often a significant opportunity cost in terms of stock market appreciation; on average, the S&P 500 has risen about 18% between the time the yield curve inverted and the peak in equity markets for the cycle.
While just one of many economic and market indicators we watch to gauge how much longer the bull market could continue, we have attempted to put a bit more precision around the yield curve’s timing signal, and we are cautiously optimistic about what it is telling us.
Our investment philosophy is driven by economics, as most bull markets tend to coincide with economic cycles. (And it has historically not been profitable to try to position around the bear market corrections not driven by economic fundamentals.) Therefore, we analyzed the bull markets occurring during the last 3.5 economic expansions: 1976–1979, 1982–1990, 1991–2001, and 2001–2007. Since bull markets are never the same length, we standardized each by slicing the S&P 500’s appreciation from trough to peak into equal parts. We then looked at where the 10-2 year Treasury yield spread was 5% of the way through each bull market, 10% of the way through, and so on. The results give us a range of values for where we may expect to see the 10-2 year Treasury yield spread at various points in the bull market (Figure 1). For example, when we have been 5% of the way through historical bull markets, the 10-2 year Treasury yield spread has ranged from 0.13% to 1.6%, with a median of about 1.3%.
Figure 1: Yield curve suggesting we are 70%–80% of the way through bull market
Data as of July 10, 2018.
Sources: Bloomberg, Standard & Poor’s, WTIA.
We can then compare today’s spread (0.28%, shown by the gray horizontal line) to take an educated guess at where we are in this current bull market. Based on where the gray line intersects the black range markers in Figure 1, it is reasonable to suggest that we are about 70%–80% of the way through the bull market. While an estimate based on one indicator alone, this would imply another roughly two years before the S&P 500 hits its peak.
This analysis is not meant to be a stock market forecasting tool, as there are many other factors we consider when positioning portfolios. Rather, this exercise helps put into perspective some of the concerns around the flattening yield curve and is supportive of our core narrative. We would never position around just the slope of the yield curve—or any other single indicator —by itself. We also acknowledge that no two bull markets are exactly the same, and we have a rather small sample size with which to work. Based on the multitude of economic and market indicators we monitor that together signal to us a recession is more than a year away, we continue to hold an overweight to stocks and an underweight to bonds.
However, market dynamics can change quickly, and we are far from complacent. Today’s yield curve slope suggests the market has further to run, but there are growing risks on the horizon: valuations are elevated; there is risk of a Fed policy misstep; and, of course, there is trade-related uncertainty. While not yet weighing on economic data, escalating trade tensions could certainly start to materialize in the form of lower business confidence and capital expenditure expectations. We expect second quarter earnings to provide investors with a homing device of sorts, re-centering focus on earnings growth and corporate fundamentals. We are more cautious than we were to start the year but believe it is prudent to maintain exposure to risky assets and ride through the current volatility, as we do not think the show is yet over.
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 Data for the 2-year Treasury begins in 1977, though a similar analysis could be performed using the 10-year and 3-month Treasury yields going back to the early 1960s.