The Floor Is Rising Under the Yield Curve
Plus, which industry groups are helped by the trend?
Let's take a look at the two- and 10-year Treasury rates and the shape of the yield curve between them as measured by their forward rate ratio (FRR2,10). This is the rate at which we can lock in borrowing for eight years starting two years from now divided by the ten-year rate itself. The more the FRR2,10 exceeds 1.00, the steeper the yield curve is; an inverted yield curve has an FRR2,10 less than 1.00.
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If we map the two interest rates on a logarithmic scale to emphasize their percentage changes, we see just how little action there has been in the 10-year Treasury note since various FOMC members went out of their way in June 2013 to assure us of their non-hawkish intentions. The situation is different for the two-year Treasury, though. It has move to its highest level since May 2011.
The net result of all this has been a flattening of the yield curve to the lowest FRR2,10 since April 2011. As the January-May 2014 flattening was a bullish one with 10-year rates declining, financial markets rejoiced even though some interpreted these lower long-term rates as a negative reflection on the economy. What is the industry group impact of this flatter yield curve for the US stock market?
Negative for REITs
If we calculate the sensitivity of each industry group's relative performance to the S&P 500 (INDEXSP:.INX) as a whole as a function of the FRR2,10 at a 90% confidence interval, we see only four groups helped by the flatter yield curve, integrated oil & gas, regional banks, soft drinks, and general merchandise retailers. I suppose you could get by with a portfolio holding ExxonMobil (NYSE:XOM), Fifth Third Bank (NASDAQ:FITB), and Coca-Cola (NYSE:KO).
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The groups with a positive partial contribution from the FRR2,10 have a much greater impact, which means the overall impact of the flatter yield curve will be negative. The list is dominated by REITs, a group that will be sad to see the hunt for yield end; the iShares Real Estate ETF (NYSEARCA:IYR) has returned almost 16% year-to-date. The same holds true for a handful of basic materials groups such as gold, steel, and diversified metals and mining.
Should you run out and position yourself for higher short-term rates? Not just yet: Janet Yellen has said in no uncertain terms that she is not worried about either inflation or financial bubbles and, perhaps more important, she is in no hurry to raise the federal government's debt service costs.
Keep things in perspective. The FRR2,10 is still steeper and two-year rates are still lower than they ever were prior to QE2 in 2010. Both will flatten and rise, respectively, in due course and will affect all capital markets, most likely for the worst. The Federal Reserve knows that "worst" part, too, and will act accordingly.
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