Add the yield curve to a long list of concerns for the rising
stock market (NYSEARCA:DIA).
This past month's bond rout (NYSEARCA:AGG) has done more than just
raise interest rates, it has raised the yield curve, and
historically that has not been a good thing for the equity markets.
As usual, though, the mainstream media and experts are getting it
wrong when it comes to a steepening yield curve.
ING Investment Management recently exclaimed concerning a
steepening yield curve, "Over the next couple of years, equity
returns will start to outperform fixed income returns. We are
also seeing yield curves steepening, which is also positive for
cyclical and value equities."
Another headline states, "Nothing bankers like more than a
steepening yield curve".
ING and the other so called experts need to look at the chart
below (or any chart for that matter), as history begs to
The History of the Yield Curve
As the yield curve steepens, the difference or spread between
long-term and short-term interest rates increases. This causes
long-term bonds to decrease in value relative to bonds with shorter
The One Indicator that Tells Us the Market's
The chart below along with our outlook for Treasuries was recently
provided to subscribers of our ETF Profit Strategy Newsletter and
shows the ten year (NYSEARCA:IEF) less the two year (NYSEARCA:SHY)
Treasury yield spread in red (also known as the yield
The S&P 500 (NYSEARCA:SPY) is also shown in blue for
comparison. Over the past 25 years, the yield curve has
started steepening sharply three times, in 1990, 2000, and
2007. If these dates don't scare you, they should, as they
all marked significant equity price and economic peaks.
The vertical lines in blue mark the yield curve bottoms that
occurred just before the recent quick steepenings of the yield
curve. Every time the curve steepened sharply, the market
soon after peaked.
Contrary to popular belief, a steepening yield curve is not
bullish for equities.
Theory Does not Reflect Reality
Many pundits and economists will suggest that a steepening yield
curve is "good for the economy" as it's a sign of future growth and
inflation. Ignore them and their theories.
One justification they provide is that the steepening yield
curve is great for banks and thus great for the economy. From
the Wall Street Journal, "The steepening is definitely good for
banks, as banks (NYSEARCA:FAS) these days make their money on the
net income margin". Well, if it's good for banks
(NYSEARCA:XLF), it stops at their margins as their stocks got
creamed during previous curve steepenings (in reality their margins
were not improved during previous steepenings).
Another popular argument is that a rising yield curve suggests an
improving economic environment as Business Insider recently
suggested, "When yields are rising from a low level, they reflect
improving prospects for economic growth". Maybe in theory, but a
glance at reality suggests otherwise.
Profiting from the Curve
A better explanation for a steepening yield curve may be a dash for
cash. A steepening yield curve means the ten year Treasury
price is falling faster than the two year. As the yield curve
steepens more money is being sent into the safer, less volatile
shorter end of the curve as opposed to the longer end. This
drives the curve higher and suggests that during times of
steepening, fear and a rush for safety are actually dominating the
markets. This makes more sense given the equity market
declines that have soon followed.
This is why we have been suggesting to our subscribers a move
into the shorter-term Treasuries such as SHY and IEF
(NYSEARCA:IEF). In our twice weekly
after Bernanke's testimony on 5/22 we wrote:
"The Fed spooked Treasuries today and the IEF now closed below
its 200 day moving average. The medium term uptrend in bonds
We followed up on 6/12 by writing:
"SHY shows how little the short end of the Treasury curve has
been affected by the recent bond scare. Parking your money
here keeps the downside risk much smaller than JNK (NYSEARCA:JNK),
HYD (NYSEARCA:HYD), MUB (NYSEARCA:MUB), or even TLT
Since our 5/22 alert, 2x and 3x inverse long-term Treasury bond
ETFs (NYSEARCA:TBT) have surged between 11% and 15.37%. By
comparison, the total U.S. bond market has been dead money in 2013
and is down 3% year-to-date. Our alert about moving into SHY alone
saved TLT investors over 5% of losses!
Besides moving to safer
shorter-dated Treasuries, another way to play a
steepening curve is to buy the iPath Treasury Steepener ETN
(NYSEARCA:STPP). It has already rallied over 15% since May
and would benefit if the yield curve keeps steepening. Past
steepenings have sent the yield curve over 250 basis points higher
from its lows. If that again is the case, then the yield
curve still would have over 150 basis points of move higher,
providing a windfall for STPP owners.
More aggressive traders or yield curve hedgers may also look
into the iPath 10 Year Bear ETN (NYSEARCA:DTYS). This product
aims to move inversely to the 10-year Treasury and should
capitalize on a continued deterioration of yields.
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