The yield curve was all the rage in 2023. As investors witnessed the deepest and longest-lasting inversion in modern history, a recession seemed all but inevitable given the yield curve’s stellar (up to that point) track record of predicting economic contractions. So a lot of ink, both physical and digital (including our own), was spent on the subject. However, now that what felt like the most anticipated recession in history has failed to materialize (at least so far), the yield curve, no longer inverted, is not getting as much attention as it used to. But perhaps it should.
Source: CWA, Bloomberg, as of 2/25/2024
As we analyze the impact that the yield curve may have on the stock market, we distinguish between six regimes based on the intersection of the curve’s level and its direction, as detailed below:
Yield curve level
- Inverted (< 0 bps)
- Moderately positive (between 0 and 100 bps)
- Significantly positive (> 100 bps)
Yield curve direction:
- Flattening (trending lower over the prior six months)
- Steepening (trending higher over the prior six months)
Currently, the yield curve is moderately positive and steepening, and this particular regime has historically been associated with the strongest performance for the S&P 500 index, as shown in the chart below.
Source: CWA, Bloomberg, as of 2/25/2024
Why is this the sweet spot? A moderately positive yield curve, compared to an inverted one, provides a much healthier environment for credit creation. The fact that it is steepening is a symptom of the fact that the Fed has been cutting short-term rates, thereby easing monetary conditions. At the same time, the fact that the curve is not yet in the significantly positive zone indicates that the Fed hasn’t needed to slash rates aggressively in response to economic weakness. This last regime (significantly positive and steepening yield curve) is the one that has historically been associated with the weakest stock market performance, so the later we get to it the better.
There are many crosscurrents currently impacting the market, but as far as the yield curve goes, we like it where it is.
Sauro Locatelli CFA, FRM®, SCR®
Director of Quantitative Research
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