Add the yield curve to a long list of concerns for the rising stock market (DIA).
This past month's bond rout (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 differ.
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 maturities.
WATCH: The One Indicator that Tells Us the Market's Mood
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 (IEF) less the two year (SHY) Treasury yield spread in red (also known as the yield curve).
The S&P 500 (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 (FAS) these days make their money on the net income margin". Well, if it's good for banks (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 (IEF). In our twice weekly Technical Forecast 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 is over."
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 (JNK), HYD (HYD), MUB (MUB), or even TLT (TLT)."
Since our 5/22 alert, 2x and 3x inverse long-term Treasury bond ETFs (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 (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 (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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