What is the yield curve?
The yield curve illustrates the interest rates (yields) for bonds with equal credit quality, but different maturity dates. The slope of the curve indicates how the much the interest rate changes as time proceeds.
The normal yield curve is upwards-sloping as longer-term debt commitments entail relatively higher risks for the issuer to default and are therefore compensated with higher interest rates than short-term debt. Hence, the yield increases with the maturity. In general, we see normal yield curves during periods of economic expansion.
Alternatively, an inverted yield curve is downwards-sloping and often occurs in economical downtrends. This is because the short-term yield is higher than the long-term yield, meaning the yield decreases as the maturity increases. This indicates a lot of uncertainty in the market as one might be hesitant to lend out capital, which is one of the reasons why an inverted yield curve is used as an indicator for economic recessions.
The greater the slope of the curve, the greater the difference in interest rates between short- and long-term debt. However, a flat yield curve means that there is no (or little) difference between debt of different maturities and that they’re expected to remain the same. This can occur when the yield curve changes from normal to inverted.
Historical and current yield curve
The Federal Reserve in the US is one of the most important central banks. This is why, generally speaking, investors refer to the US yield curve when using the term “yield”. Another term that is used interchangeably is “treasury”. The US yield curve ranges from 3 months to 30 years, where short-, mid- and long-term bonds are often addressed by the front, belly and tail of the curve respectively. Maturities that are most used are 3 months (T-bills) and 2, 5, 10 and 30 years.
As you can see from the chart below, the current difference between the US 3-month and 10-year yield curve increased since the beginning of the year, meaning that we are currently seeing a steepening of the yield curve.
Correlation between yield and stocks
In theory, the stock market and interest rates are negatively correlated. This is because stocks are valued using the DCF-model, which discounts back all future cashflows to today using the interest rate. Hence, if the discount rate goes down (smaller denominator) and the cashflows (numerator) remain unchanged, then that would equate to a higher stock valuation. A less mathematical explanation is that when interest rates are low, less people are willing to save their money in the bank and seek alternative investments such as the stock market.
In practice, however, interest rates are historically positively correlated (weakly) to changes in share prices. This because higher interest rates indicate higher economic growth, which is positive for future cash flows and therefore share prices. In summary, although higher interest rates mean that cashflows are discounted with a higher discount factor (negative effect), the higher interest rates could be due to a higher economic growth outlook (positive effect).
The low yield is one of the reasons of the Nasdaq’s high level
Our Head of Equity Strategy Peter Garnry explains how the DCF mechanics explained in the previous paragraph caused a high Nasdaq level. The left chart below shows that earnings within the index remained relatively stable over the last years, hence the rally in stock prices cannot be explained by their earnings growth. However, the right chart shows that yields have been decreasing over this same period. When using a DCF valuation model, this lower discount rate would lead to higher stock valuations and is therefore the more likely driver.
Alternatively, a strong increase in the yield could cause a correction in the Nasdaq. A yield increase could happen as the Biden administration might initiate large financial stimulus, which could increase the inflation expectations stirring up the reflation trade.
Given the current low-interest-rate environment, only small changes in the yield lead to large changes in stock valuations. High-growth companies are especially sensitive to interest rates. This because a much larger part of their value today is derived from cash flows from far into the future, which will be discounted more when rates go up. Moreover, higher rates often reflect outlook five years out but growth companies get the majority of their cash flows far beyond this horizon.
Example: Microsoft is currently trading at a 3% free cashflow yield, which is the discount factor used for the cashflows. An increase of this free cashflow yield to 4% would lower its market value by around 25% (assuming unchanged earnings and free cashflow). This shows the magnitude of a 1% move in the interest rate. As we get closer to zero with interest rates, everything becomes supercharged.
The current US vs German yields
As mentioned before, the Biden administration might cause a steepening in the current yield structure. The front of the yield curve is stable due to yield curve control by the FED. However, the tail of the curve is more volatile and could go up, which is called a “steepening” of the yield curve. Alternatively, a “shift” of the yield curve means that the entire curve goes up, meaning that yields increase across all maturities. The charts below show a steepening in both the US and German yield curve. The US 10-year yield curve reached new highs since spring and the German 30-year yield rose even further. The increase in the US 10-year yield is a stronger signal than the increase of the German 30-year yield as the the 30-year is generally more volatile than the 10-year due to its longer duration.
Bear case: US government bonds fall due to higher yields and inflation
Yields follow inflation, which is likely to go up due to all the government stimulus. If yields go up, bond prices will fall. This is the reason why investors have reduced their positions in long government bonds. The chart below compares the net long positions between the S&P 500 and the 30-year US government bonds. The chart indicates a record long position for the S&P 500.
Main market consensus: short government bonds
The chart below confirms the bear case for the US 30-year government bonds. The candle sticks show the development of the 30-year yield, which was trading around 160 basis points (1.6%) at the time of writing. This means that you receive 1.6% per year if you “park” your money for 30 years at the US government, which is very low assuming that inflation could rise to around 2%. Hence, there is a risk that investors will sell their bonds at a lower price, or hold the bond until its maturity taking a loss on each coupon after correction for inflation. This is why the market consensus is short US treasury positions. The orange line in the chart below represents the position of the market, which shows that around 260,000 contracts are net short in commercial treasury positions. Hence, this suggests that investors do not want to hold US government bonds.