March 3, 2021
Scott Wren, Senior Global Equity Strategist
Reading the yield curve tea leaves
- The yield curve has been steepening recently as longer-term rates and inflationary expectations have increased.
- In our opinion, expectations for much improved economic growth and only modestly higher inflation have been the positive drivers of this trend.
Check in with your favorite financial news source and almost certainly that outlet will be spending quite a bit of time talking about the “steepening” yield curve and its potential impact on stocks and bonds. Economists and market strategists often try to predict what the shape of the yield curve will be looking forward. Having a feel for what it will look like down the road can be a useful guidepost for predicting economic strength and market direction.
The yield curve, in its most basic form, is simply a timeline that illustrates where yields on U.S. Treasury securities stand at any given point in the future. The yield curve can give investors a visual perspective on where rates are in the nearer term (i.e., three months, one year, two years) relative to longer-term rates (i.e., 10 year, 30 year). Historically, most of the time, short-term interest rates have been below long-term rates. As an example in everyday life, think about 15-year fixed mortgage rates being lower than 30-year fixed rates or two-year certificate of deposit (CD) rates that are lower than five-year CD rates.
When shorter-term interest rates are lower than longer-term rates, the yield curve is said to have a positive slope. This is considered “normal.” Picture a chart with a line moving from left to right connecting various yield levels. The vertical axis on the chart represents percent yield while the horizontal axis represents time (i.e., months, years). A line that moves up and to the right reflects a positive sloping curve. Now let’s tie this to expectations for economic growth and inflation.
As we believe to currently be the case, a steepening yield curve early in a new economic cycle typically reflects the market’s belief that economic growth and inflation are or will be on the rise. It is a gauge that can help confirm whether a recovery is at hand (a good thing) as the economy climbs out of recession or a meaningful slowdown. In recent months, the yield curve has been getting steeper as, expectations for better economic growth and higher inflation (as the Federal Reserve desires) have increased. Note that the values of longer-dated Treasury securities are more sensitive to perceived or realized increases in inflation than short-term Treasury securities.
Our current strategy work suggests robust economic growth this year with a modest increase in inflation. While we do favor equities, we do see some opportunities in fixed income specifically in preferreds and in the intermediate portion of the yield curve. We do not expect to see inflation move sustainably higher in coming years. In attempting to read the tea leaves, the steepening of the yield curve, in our opinion, reflects the market’s belief that growth and inflation should continue to move back toward appropriate levels as the pandemic eases. We view this as a positive for stocks and other risk assets, like commodities.
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. Although Treasuries are considered free from credit risk they are subject to other types of risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate. Preferreds securities have special risks associated with investing. Preferred securities are subject to interest rate and credit risks. Preferred securities are generally subordinated to bonds or other debt instruments in an issuer's capital structure, subjecting them to a greater risk of non-payment than more senior securities. In addition, the issue may be callable which may negatively impact the return of the security. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility.
An index is unmanaged and not available for direct investment.
S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.
Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.
The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.
The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability or best interest analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. The material contained herein has been prepared from sources and data we believe to be reliable but we make no guarantee to its accuracy or completeness.
Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors.
Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company.