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Yield Curve and the Stock Market

5/21/2009

How will the steep yield curve and the prospect for higher interest rates affect stock prices? The shape of the yield curve has an important affect on the trend of the stock market. Add in the prospect of higher interest rates and the outlook for the stock market becomes more of a concern.

A steep yield curve means companies selling longer-term corporate bonds must pay more for the privilege. It shows that interest rates affect investors in the stock market.

Background on the Yield curve

One of my first papers I had to write in college was on the “Term Structure of Interest Rates”. The purpose was to discuss how interest rates change over a time and how to interrupt the rates of different maturities at a point in time. I am not sure I understood what I was writing at the time. Since then it has become much clearer and the term “yield curve” provides a much better image in the mind.

The yield curve is a plot of the yield on bonds with the same credit quality across different maturities. The basic assumption is you get more interest on your investment in a bond by holding it longer. The theory states there is more risk for holding a bond for 10 years than for 5 years, or for 5 years than for 90 days. Simply, the yield curve is a graph showing bond yields on the vertical axis and different length maturities of any type of debt instrument such as government bonds and notes on the horizontal axis.

Generally, the longer the maturity of the debt an investor is buying, the greater the yield any given bond will carry. This is because there is more risk to principal the longer the maturity of the debt. The more risk an investor carries, the higher return he should expect.

There are four ways to describe the yield curve at any given time: normal, steep, flat, and inverted. When the economy is growing normally without any fear of inflation or other economic disruptions, the yield curve slopes gently upward. Investors who risk their money for longer periods expect to get a bigger reward in the form of higher interest than those who risk their money for shorter periods. This creates a normal sloping yield curve.

A steep curve occurs when the longer-term bonds have much higher yields than the short-term notes. Investors have a greater fear that inflation is rising, which causes interest rates to be much higher at longer maturities.

The yield curve is flat when there is little difference between the long and short-term securities. This tends to take place when the economy is in transition and the yield curve is forecasting the change. A flat yield curve is normally a temporary situation.

An inverted curve takes place when the rates received on long-term bonds are less than the rates received short-term notes. When the economy is expected to go into a recession, especially a severe one, investors will settle for lower yields now if they think rates and the economy are going even lower in the future. They are betting that this is their last chance to lock in rates before the bottom falls out.

The shape of the yield curve can help tell us the trend in interest rates. Since longer-term rates are much higher, a steep yield curve tells us that the market is expecting rates to increase in the future. Investors want to be protected from loosing current principal value, so the market is generally selling the longer-term bonds. Rates move opposite bond prices. Therefore, when investors sell longer-term bond, rates rise. Rising rates at the long end of the curve hint that inflation is more of a concern.

On the other hand, a flattening or inverted curve, where long-term rates are falling relative to or below the short-term rates, means that the bond market expects interest rates to decline in the near future. This is due to traders bidding up (reducing the yield of) the longer-term bonds because the market expects the higher-yielding bonds to have a higher principal value in the near future. Falling interest rates actually raise the value of the longer-term bonds.

The yield curve represents the bond market's expectation of where interest rates and the economy are going. Many investors consider bond traders the best at understanding the economy and the markets. Stock traders monitor what bond traders are doing and their interpretation of interest rates and the yield curve. The trend of interest rates and the yield curve help to forecast the trend of the stock market.

Credit Spreads Widening

As longer-term interest rates rise, it causes longer-term investment grade credit spreads to widen further. In fact, these credit spreads are currently at or near their widest levels in decades. In some sectors, they are approaching the widest since the Great Depression. This asset class has not been so attractively valued in a very long time. Yields at or around 7% to 8% on investment grade corporate debt are attracting investors who expect equity returns to be low over the next several years. In addition, Treasury yields are now near historical lows, as the Federal Reserve has stepped in to help stimulate the economy with lower rates. Given the current economic environment, corporate profits are likely to grow at roughly the same pace as nominal gross domestic product (GDP). For a variety of reasons, GDP will be below historical trends. In addition, dividends, currently around 3.5% on average, may be cut further to help companies preserve cash. If either or both of these events take place, it will render the stock market far less attractive than investment grade corporate bonds.

Credit Spreads chart

The expanding deficits in the U.S. require the Treasury to sell more bonds to provide the money for the government to spend. While still considered a safe investment, investors will require higher rates to meet their return expectations, as we saw in the Treasury auction the week of May 4, 2021. We should expect the treasury yield curve to steepen even further over the next few months. As the Treasury yield curve gets steeper, it will cause the rates of other debt securities to rise, as they must compete for money. Investors should consider what if the ratings on U.S. government securities received less than the best rating.

Affect of Interest Rates on Stock Prices

Bond investors are closely aligned with the economy, as interest rates are a key determinant of economic performance. Stock investors are aware of interest rates, though they focus on companies and their individual performance. As investors, we are very interested in the direction interest rates will go over the next few months and years.

In theory, rising interest rates should be good for stocks. Rates tend to rise when the economy is recovering from a down turn. However, higher rates can also be a determent to an economy that is recovering. That is why the Federal Reserve is keeping short-term rates near zero. However, controlling long-term rates is much more difficult. The hidden hand of Adam Smith steps in and forces all entities to deal with the realities of economics.

When rates go up, many investors who had been buying stocks seek safety, buying bonds to receive their higher yields. When investors perceive they can get better returns from long-term bonds than from stocks it takes money out of the stock market. This tends to put downward pressure on stocks prices. In addition, companies that sell long-term debt will pay more now that rates are higher. This reduces their earnings power.

As the yield curve gets steeper, it puts downward pressure on stock prices. Like all securities, bond yields do not rise or fall in a direct line. Rather they zig and zag along the way. As the rates for Treasury bonds climbs, they will place downward pressure on stock markets. This is one more factor stock investors need to consider as they make their investment decisions. It does not mean there will not be excellent investing opportunities for equities investors. It just adds to the analysis of the trends for the stock market.