There is more than one way to explain the effect of Treasury yields on US stocks.
Ed Clissold, chief U.S. strategist, and Tan Nguyen, chief quantitative analyst, describe at Ned Davis Research three scenarios in which the direction of short- and long-term bond yields and moves relative to each other lead to “interesting—albeit complex—messages for the stock market.”
The bottom line is that the S&P 500 SPX tends to rise at a good rate except for periods of “bullish slope”, where the 10-year BX Treasury yield: TMUBMUSD10Y declines, but at a slower pace than its 2-year BX counterpart: TMUBMUSD02Y.
It is often assumed that rising Treasury yields are bad for US stocks in general, but research by Clissold and Nguyen comes to more nuanced conclusions. They found that higher returns, which occur when investors sell underlying government debt, can be quite consistent with risk sentiment in equities, based on data spanning more than 40 years.
“The conventional wisdom is that higher returns are negative for equities because it increases the cost of borrowing for companies and provides competition for asset allocators,” Clissold said by phone Thursday. However, higher yields could also be a sign that the economy is proving more resilient than expected. Moreover, when recession risks appear high, rising bond yields can reflect the Treasury market’s view that a recession is not imminent, “which would be bullish for stocks.”
Markets have been closed in what’s known as a “bear flattening” environment since March 29, 2021, according to Clissold — a period that captures the S&P 500’s all-time closing high of 4,796.56 on January 3, 2022. The NDR uses a 150-based basis-point swing in the curve Treasury to determine when the markets switch to a different order.
“Bear” refers to the investors’ decision to sell Treasurys, which results in higher returns. The term “bull” refers to a government bond-buying environment, which leads to lower yields. Steepener and flattener describe the shape the Treasury curve takes as a result, based on moves in the 2- and 10-year rates.
Here’s how NDR’s research, released on Wednesday, breaks down:
- bull slope. A bull run occurs when both the 2- and 10-year returns are declining, but the short-term rate does so at a faster pace. In theory, that will happen when recession fears pick up again. Not only is the long-term outlook turning more pessimistic, but traders and investors see even more reason for the Fed to start cutting interest rates in the near term. Clissold and Nguyen write that the upward slope “was the worst stock-returning curve system.” “The economic message from someone who is so steep is that the economy is so slow that the Fed is likely to cut interest rates. The market is mindful of the risks of policy error.” The last time such a system was in place was between August 27, 2019 – August. 4, 2020, the period that includes the onset of the Covid-19 pandemic in the United States
- bear slope. A bear slope occurs when the 10-year yield rises and does so faster than the 2-year rate. Such a move usually occurs in a situation where traders and investors see bright prospects for economic growth in the US in the long run. “The overall message is that the economy is strengthening, and the Fed is expected to rise. In other words, the economy is getting the pretty clear message, but the Fed has not been over-tightening.” The last time the Bear Downhill system was in was from August 4, 2020, to March 29, 2021, according to the NDR. However, yields can sometimes rise for the wrong reasons, as happened last week as growing concerns about the US fiscal outlook sent the wind out of stocks.
- Flatten the bear. Finally, there is the bear flattener, which is produced when the 10-year yield has been rising but at a slower pace than the 2-year rate. In other words, traders and investors sell both the underlying maturities, but they do so more aggressively with the two-year Treasury. Under the downward flattening regime, which has been in effect since March 29, 2021, “the yield curve indicates that the economy is still strong, but the market is beginning to anticipate conditions that may subside to the point that the Fed may need to cut.”
On Thursday, all three major US stock indexes were trying to bounce back even after the head of the San Francisco Fed Mary Daly He told Yahoo Finance it’s too early to say whether the central bank has done enough about rates. Meanwhile, the two-year Treasury yield rose to 30 after an auction of the 30-year note.