What the Yield Curve Can Tell Equity Investors

Key points

  • The U.S. Treasury yield curve, which flattened for much of 2017, when spreads between long and short maturities recently narrowed to decade lows, has begun to steepen.
  • Investors historically have viewed the shape of the yield curve as a signal of future growth. We believe the yield curve is currently suggesting continued economic expansion.
  • The ETF Investment Strategy team documents the historical relationship of equities to different yield curve regimes over the last 20 years.
  • Against the current backdrop of sustained global expansion, our preferred sectors include cyclicals, specifically financials and technology.

The yield curve: An explanation

The yield curve compares interest rates at different maturities, typically the spread between yields on two- and 10-year bonds. Ten-year yields historically have reflected the market’s growth and inflation outlook, while the short end of the curve is mainly tied to market expectations for Federal Reserve policy rates.

The yield curve flattened for much of 2017, primarily due to a rise in short-term yields. While a flattening yield curve can signal slower growth, rising short-term yields in 2017 showed greater market confidence in the growth and inflation outlook, which also carries expectations the Federal Reserve will continue to normalize policy rates. It would be worrying if the curve had flattened because 10-year yields were falling on concerns that Fed policy tightening might crunch growth and inflation. Instead, low inflation expectations kept rises in 10-year yields in check, while declines in yields on even longer maturities largely reflect strong foreign buying and demand from institutions seeking to hedge risk.

However, in early 2018, the strengthening global economy and U.S. fiscal stimulus are expected to be heralding a turnaround in market sentiment with rise in inflation expectations, reflected in rising long-term bond yields. The yield curve has steepened somewhat in 2018, although we don’t expect long-term yields to rise sharply this year.