Asset Allocation Implications of a Flattening Treasury Yield Curve
The Treasury yield curve has started to flatten in recent weeks. Based on historical relationships, this process is likely to have important implications for investors because it signals that the business cycle has moved to a more self-reliant and less Fed dependent state.
The yield curve is the ratio between a short maturity credit instrument and a mid- to long-term one. There are many ways to calculate it but one of the most popular spreads is to compare 2-year notes to 10-year treasuries as shown in Chart 1.
The 2/10-year Yield Curve Spread vs. the Yield on 3-month Commercial Paper
The yield curve is in the early phase of flattening.
In recent weeks, several aspects of the treasury yield curve, including this one, have started to flatten. Flattening occurs when short rates out-perform long ones, and that usually means they are moving up faster rather than falling less slowly. When short rates move above long ones, the curve is said to be inverted. This reflects a severe tightening in the system which is invariably followed by a recession. Note that the curve has broken out from a 3-year base which indicates the flattening process has just begun. This spread is not the only one to have broken out. Several others, such as the 5-20-year ratio, have as well. This broad participation adds credibility to the view that the flattening process is for real.
This flattening process has several implications:
1. The early stages of a move towards inversion, where we are now, reflect a healthy level of business activity experiencing little in the way of inflationary distortions. It’s actually a good thing because the economy is able to prosper without the artificial support of excessive central bank stimulation.
2. As we see from Chart 1, cyclic lows in the curve either develop simultaneously with the yield on 3-month commercial paper or, as has been the case more recently, represented a leading indicator for short-term rates. This spread actually reached its low in 2011, so the March breakout signals the second stage in the move towards flattening. This process is the market’s way of reflecting a tightening in the system, which sooner or later, will be followed by Fed actions. Provided the curve continues to flatten, the implication is that pressure will build on the Fed to raise short-term rates sooner than is currently expected rather than later.
3. Chart 2 demonstrates that a flattening yield curve is often associated with rising industrial commodity prices. The green oscillator measures the long-term smoothed momentum of the 2/10-yeld curve and the thin black line the CRB Spot Raw Industrials. Because a flattening curve does not universally translate into rising commodity prices, it’s necessary to include some form of a triggering device to confirm that commodities are responding to this condition. In this case, it’s the Index being above its 12-month moving average (MA), as represented by the blue line. The green shaded areas develop when the momentum of the yield curve is rising and subsequently is confirmed by the commodity index maintaining a position above its 12-month MA. This condition represents a very positive environment for prices, and one that has been in force for the bulk of 2014.
The 2/10-year Yield Curve Momentum vs. Industrial Commodity Prices
Rising yield curve momentum is usually associated with rising industrial commodity prices.
4. Chart 3 compares the curve to equity prices. In this case, the green shading reflects periods when both series are above their respective 12- month MA’s. With the exception of 1981, this environment proved to be a positive one for stock prices. The curve is currently flattening and is above its MA. So long as the S&P remains above its average (estimated to be at 1765 at the end of April) that beneficial environment will continue.
The 2/10-year Yield Curve Spread vs. the S&P Composite
The early phase of a flattening yield curve is usually bullish for stocks.
5. The final implication of a flattening yield curve comes much later, when short rates actually cross above longer-term ones. This state of affairs is represented in Chart 1 as a plot above the dashed brown line at 1.0. That’s the point at which the curve is said to invert. This is indicative of tight money, which sooner or later causes the economy to fall into recession. By way of example, the chart shows that each recession since 1980 was preceded by an inversion. Chart 3 shows that when stocks respond to an inverted curve by crossing below their MA, a recession associated bear market typically follows. The four previous instances since the late 1970’s have been flagged in Chart 3 by the red arrows. Unfortunately, the lead times vary, but the fact that the curve is currently in the early phase of flattening should postpone any thoughts of economic contraction for a while. Only after a multi-month advance in the curve and an actual inversion should we begin to worry about the next recession.
For the time being though, asset allocation should be oriented, as we have done for the Pring Turner Business Cycle ETF (DBIZ), towards earnings driven equities and commodities. An overstretched equity market also argues for a healthy dose of cash. The big danger from here, as we see it, is that industrial commodity prices respond to economic growth in a stronger way than is generally expected. That would certainly accelerate the flattening process and threaten the recovery. Not a forecast, but something for investors to bear in mind.
Martin Pring Strategist for Pring Turner Capital Group and the Pring Turner Business Cycle ETF (DBIZ)