Watching Interest Rates to Understand Equities

The latest chatter about the steepening of the yield curve between the yield of the US Government 10 year bond (minus) and the 2 year bond is no big deal.

That differential (“the spread”) is currently at 1.56%, 

(that’s how much the 10 year bond is yielding above the 2 year bond and it is represented in a plotted graph, we call the yield curve)

Yes, it’s the widest spread since September 2015, but it’s not extraordinary.

It has been twice that amount (3%) on several occasions over the past 30 years. (see chart below)

There is some exaggeration about how steep the curve is…it actually isn’t.

Don’t worry too much about that yield curve at the moment.

My story is about when the spread actually touched Zero (which is when the 10 year bond was offering the same yield as the 2 year bond) and not so much the actual spread nor the yield of the 10 year bond.

And then I have added comments to what happened to the equities market afterwards.

Example #1

In April 1998 the spread touched Zero,

but the S&P 500 continued to rise until the S&P 500 peaked in March 2000; some 21 months later.

A year earlier, in April 1997, the 10 Year Bond (“the 10’s) was yielding 7%. 

By April 1998 it had fallen to 5.6% (when the spread was Zero)…..

the yield would decline a little more, down to 4.4%.

By March 2000, it had climbed back to 6.66% to coincide with a peak in equities market.

Example #2

In January 2006, the spread was at Zero again, but stocks rallied for a further 17 months until the S&P 500 peaked in October 2007.

From that moment in January 2006, the 10’s rose from 4.3% to 5.3% on a couple occasions, reaching that same 5.3% peak in July 2007, just as economies were about to experience the ‘Global Financial Crisis’.

For a period of 6 weeks, the 5.3% yield did break above the downward sloping trend line (see the chart below) but the precedent of a Zero spread being registered 17 months earlier held sway.

Example #3

By December 2008, 10’s had fallen to 2% (although the spread didn’t flirt with Zero, it never went below 1.2%).

From this ebb, the yield doubled to 4% over the next 18 months (April 2010).

The stockmarket fell 20% over the next few months.

Example #4

Through stages of the GFC recovery, 10’s were back to 1.4% in July 2012.

Within the next 18 months (by December 2013), the 10’s doubled to 3%

The stockmarket rally was stifled and went sideways for 5 months.

Even though rates doubled, equities remained in a bull market because we never saw a Zero spread registered.

Equities resumed their rally as 10’s commenced a new decline in yields from 3% down to 1.7% over the next 14 months, being until January 2015.

Note: The United States Federal Reserve kept the Fed Funds Rate at Zero between 2008 and 2015.

Example #5 (the anomaly)

By July 2016, 10’s eased a little more to 1.35%. From there, they nearly doubled again (to 2.6%) within 5 months and then touched 3.2% by November 2018.

Although rates nearly trebled…..they never registered a Zero spread reading. Furthermore, the anomaly is that the 10’s yield broke above the sloping downtrend resistance line (see chart below), which gave the S&P 500 ‘carte blanche’ to rally….all until the 10’s yield crossed back beneath that (now and new) support line in the month of August 2019.

Example #6

In the next month, September 2019, saw another Zero spread registered. 

While absorbing an abrupt correction, the S&P 500 has soared and continually set new all-time highs, 18 months hence.

Today, the 10’s have Quadrupled from their 0.40% March 2020 low, to its current 1.72%.

Uncannily, we are 18 months further along since the spread touched Zero and we have seen an equity market participate in extraordinary gains…….

I will re-iterate…….the interest cost of government debt has Quadrupled within 12 months.

That matters to investors and to the government servicing the interest payments.

But we are at a moment, similar to the anomaly explained in Example #5.

Forget the ’spread’ and steepening yield curve, but let’s say the 10 year bond yield reaches 2% and decisively breaks above that sloping downward line, then it’s plausible that the S&P 500 rallies for a further 18 months.

This bullish scenario may represent the ‘last leg’ in the 11 year bull run which commenced at the March 2009 low.

Although, greater probability suggests (coinciding with fundamental valuations and various sentiment and anecdotal indicators) that the quantum of quadrupling interest rates will prove a greater weight on equities plight for further gains. 

This is the measured reason why I have shifted client equity portfolios to 35% cash position and hedged portfolios with put options. This was mentioned in my January 2021 newsletter.

March 21, 2021

by Rob Zdravevski

rob@karriasset.com