Yield Curve (Murphy)

WHY A STEEPENING YIELD CURVE HURTS THE DOLLAR AND HELPS COMMODITIES... One of our readers asked me to explain my statement that a steepening yield curve hurts the dollar. Chart 1 shows the track record since 1998. The red line is a ratio of the the 10-Year T-Note Yield to the 2-Year Yield. At the start of 2001, the Fed started lowering short-term rates aggressively to combat a new recession and fear of global deflation. That caused short-term rates to fall much faster than long-term rates and caused the spread between them to widen. That led to a big steepening of the yield curve which lasted into 2003. The U.S. Dollar Index (green line) stopped rising at the start of 2001 and, within a year of the steepening, began a huge decline.

Chart: $UST10Y:$UST2Y
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COMPARISON SINCE 2004... Chart 2 shows that generally inverse relationship between the yield curve (red line) and the dollar (green line) has also been evident since 2004. After peaking in 2003, the yield curve started narrowing during the first half of 2004 and continued to drop until the start of 2006. The Dollar Index stabilized in early 2004 and moved sideways until the start of 2006. As the yield curve stabilized in early 2006, the dollar started dropping. The upturn in the yield curve in mid-2007 coincided with another downleg in the dollar to a record low. The reason has less to do with long-term rates than with short-term rates. The yield curve steepens when the Fed is in an easing mode and narrows when the Fed is raising rates. Fed easing usually coincides with economic weakness which hurts the dollar. Fed tightening usually coincides with economic strength which helps the dollar.

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WHAT'S THE IMPACT ON STOCKS ... Another reader asked the impact of the yield curve on stocks. Chart 6 shows their relationship since 2000. There's a generally inverse relationship. A steepening yield curve from 2000 to 2003 coincided with a bear market in stocks. The yield curve peaked in mid-2003 as stocks bottomed. It turned up again in mid-2007 as the market was peaking. How about bonds? Chart 7 shows that there's been a positive relationship between bond prices and the yield curve since 2000. That makes sense. Bonds usually outperform stocks when the Fed is easing (a steeper yield curve), and stocks do better when the Fed is neutral or tightening (flatter yield curve).

$UST:$SPX

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YIELD CURVE AND COMMODITIES ARE LINKED... I drew a couple of other conclusions last week. One was that the long bond was starting to underperform shorter maturities which suggested that investors should move to the shorter part of the yield curve. That's because the long bond will lag behind shorter maturities as inflation pressures mount. And the fact that commodity prices are trading at record highs suggests that will happen. Another factor working against the long bond is the steepening of the yield curve. That occurs when short-term rates fall faster than long-term rates (as the Fed lowers short-term rates to help the economy). But there's another factor to consider and that's the impact of inflation. Chart 5 plots the CRB Index (red line) and the 10-Year T-Bond yield (blue line) relative to the 2-Year T-Bond yield (flat black line). [In other words, we're comparing the direction of the yield curve to the direction of commodities]. Notice the strong correlation between the two lines. The chart suggests that a steepening yield curve is normally associated with rising commodity prices. There are two reasons for that. A steepening yield curve weakens the dollar which pushes commodity prices higher. Rising commodities, in turn, cause the yield spread to steepen. Since bond prices trend in the opposite direction of yields, a steepening yield curve favors investments in shorter maturities in a climate of rising inflation. It also favors some exposure to Treasury Inflation Protected Securities (TIPS).
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YOU CAN SHORTEN MATURITIES WITH TIPS... Last Friday, I plotted a ratio of the Treasury Inflation Protected Bond ETF (TIP) divided by the 20 Year Bond ETF (TLT) to show that money was starting to flow out of the long bond into TIPS to protect against rising inflation pressures in the form of record commodity prices. Chart 5 is another version of the same ratio and shows that process beginning last December and accelerating during January. In addition to the inflation protection TIPS offer, you also get the benefit of shorter maturities. Although TIP maturities range from one to 25 years, its biggest concentration ranges from 5-10 years (39%) to 1-5 years (31%). That puts 70% of its bonds with maturities of less than 10 years. A couple of Inflation-Protected mutual funds I checked put maturities in the 8-9 year range. Chart 6 shows one of them. TIPS offer a way to hold shorter-maturity bonds with some protection against inflation either through a mutual fund or an Exchange Traded Fund.