What the Yield Curve May Be Trying to Tell Investors

So far, November has given investors much to cheer about. Through mid-month, the S&P 500 index has risen some 300 points, roughly 10%. Catalysts included progress on a vaccine, better-than-expected third-quarter corporate earnings and a U.S. election that seems to have delivered a divided federal government, where the executive and split legislative branches may compromise to get some things done, but probably nothing too major.

A couple of additional positive signs to keep in mind: a 17-year high in manufacturing new orders, which should help sustain forward corporate profit growth; and the Fed’s unprecedented monetary stimulus, with monthly bond purchases totaling $120 billion, or the equivalent of 6% of projected 2021 real GDP.

This is all in line with our unwavering forecast for a V-shaped economic recovery. Yet, even though the S&P 500 reached an all-time high of 3585 last Friday, that isn’t meaningfully higher than previous 3581 peak on Sep 2. From our vantage point, the market remains in a period of range-bound consolidation. 

What will it take to break out? The yield curve, a market indicator based on the bond market, suggests investors aren’t yet convinced of our reflation narrative, in which expansionary economic policies spur long-term growth and inflation. If they were, the yield curve would be much steeper.

Currently, the difference between the interest rate of a 10-year Treasury (0.90%) and a two-year Treasury (0.18%) is just 72 basis points, or about three-quarters of a percentage point. This is the steepest reading since the bear market in March, but it remains well below the 40-year average of about 100 basis points, and is meaningfully below peaks of more than 200 basis points when the U.S. economy has exited recessions in the past.

To really achieve the sustained market-leadership rotations we anticipate—from growth to value, defensives to cyclicals, mega-cap to small-cap, U.S. to international; and from long-duration government bonds toward credit—we first need to see a meaningful steepening of the yield curve.

That could require more positive developments in fighting the pandemic and certifying election results, which would likely have bearing on the timeline for a new federal relief package—a factor that may determine the ability of many small businesses and the unemployed to stay financially afloat.

We have been impressed by the yield curve’s status as an aggregate barometer of the complex dynamics at work between Fed policy, real economic growth, inflation expectations and earnings growth. While no one was thinking of a pandemic in the fall of 2019, we can’t help but note that the inverted yield curve—historically, a reliable forward indicator of recession—came six months before the current recession.

That’s why we suggest investors keep their eyes on the yield curve and remain patient. A decisive steepening could presage a full emergence from the COVID-19 recession and point to a reflationary rotation in stocks and credit markets. While early November’s move in the S&P 500 has been noteworthy, it remains incomplete, as long as yield-curve steepness stays well below long-run averages. 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Nov 16, 2020, “All Eyes on the Yield Curve.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.