Is the Yield Curve Indicating Better Tidings?

By: Prieur du Plessis | Wed, Jul 22, 2009
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While the deflation/inflation debate rages on, the jump in US government bond yield (and stronger commodities and weaker US dollar) seems to indicate that deflationary pressures are moderating.

The chart of the US 10-year Treasury Note yield shows a clear uptrend since the end of last year, with the yield also now trading above both the 50- and 200-day moving averages.


The graph below shows the relatively flat yield curve (red line) immediately prior to the first rate cut in September 2007. As indicated by the black line, the yield curve has steepened dramatically since as monetary policy kept shorter maturities at low levels while longer maturities have been in a rising trend.


A steeper yield curve typically heralds better tidings for economic growth, although concerns about massive issuance also come into play. The graph below shows the close relationship between the US GDP-weighted Purchasing Managers Index (PMI) and the US 10-year Treasury Note yield.

Source: Plexus Asset Management (based on data from I-Net Bridge)

This raises the question as to what the impact of the yield curve typically is on the stock market. The blue line in the chart below shows the US 10-year Treasury Note yield relative to the US 2-year Treasury Note yield. A rising blue line indicates a steepening yield curve, whereas a downward trend shows the opposite. A comparison with the S&P 500 Index highlights a broadly inverse relationship, i.e. stocks fall when the yield curve steepens and rise when the curve flattens.


A key observation, however, is that the stock market usually bottoms prior to a peak in the yield curve, i.e. as confidence regarding an economic recovery gains ground and earnings prospects improve.

Importantly, the steepening of the yield curve comprises two phases: firstly, when both short- and long-term rates fall but short rates fall more than long rates as a result of poor economic conditions and, secondly, when long rates start discounting better economic prospects but short rates are still kept at low levels. The subsequent decline in the yield curve is when both short and long rates increase, but short rates rise faster than long rates. Share prices typically rise during the second phase of the steepening of the yield curve and the ensuing decline.

The above analysis is merely one cog of the wheel, but seems to support the argument that US stocks are in all likelihood in a broad bottoming-out phase. As said before, investors will now focus on the second-quarter earnings reports as a test of whether stock prices bear resemblance to fundamental reality. In the meantime, a cautious approach is warranted but that should not preclude one from finding stocks that look cheap.

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Prieur du Plessis

Author: Prieur du Plessis

Dr Prieur du Plessis

Dr Prieur du Plessis

With 25 years' experience in investment research and portfolio management, Dr Prieur du Plessis is one of the most experienced and well-known investment professionals in South Africa. More than 1 000 of his articles on investment-related topics have been published in various regular newspaper, journal and Internet columns. He also published a book, Financial Basics: Investment, in 2002.

He holds the following degrees: BSc (Quantity Surveying) (Cape Town), HonsB (B & A) (cum laude) (Stellenbosch), MBA (cum laude) (Stellenbosch); and DBA (Doctor of Financial Management) (Stellenbosch).

Prieur is chairman of the Plexus group of companies, which he founded in 1995. Previously he was general manager: portfolio management at Sanlam, responsible for the management of investment portfolios with total assets in excess of $5 billion.

Plexus is a pioneer in the mutual fund industry and has achieved a number of firsts under Prieur's leadership. These include the authoritative Plexus Survey, a quarterly analysis of the consistency of the performance of unit trust management companies, the Plexus Offshore Survey, the Plexus Unit Trust Indices, and the PlexCrown Fund Ratings.

Plexus is the South African partner of John Mauldin, American author of the most widely distributed investment newsletter in the world, and also has an exclusive licensing agreement with California-based Research Affiliates for managing and distributing its enhanced Fundamental Index™ methodology in the Pan-African area.

In 2001 Prieur received the Santam/AHI Business Leader of the Year award for corporate leadership, business acumen and entrepreneurial flair. He was also profiled in the book South Africa's Leading Managers (2006). Plexus received the AHI/Old Mutual Enterprise of the Year award in 1997 and was also included in the book South Africa's Most Promising Companies (2005).

Prieur is 52 years old and lives with his wife, TV producer and presenter Isabel Verwey, and two children in Welgemoed, Cape Town. His recreational activities include long-distance running, motor cycling and reading. He belongs to the Cape Town Club, Johannesburg Country Club, Gordon's Bay Yacht Club and Swiss Social & Sports Club.

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