Indicator of the Week: The Lowest Yield Spread Since 2007

The yield curve hasn't been this low since the financial crisis

by Rocky White

Published on Jun 8, 2016 at 6:00 AM
Updated on Jun 24, 2020 at 10:16 AM

There has been a lot of talk lately about the yield curve and what it is telling us. Specifically, the yield curve is flattening and this supposedly indicates troubles ahead. This week, I'll take a look at how stocks have behaved depending on the shape of the yield curve and see if the worries are justified.

The yield curve is made by plotting the yields on U.S. Treasuries at different maturity dates. The chart below shows the progression of the yield curve over the past couple of years. You can see how the current yield curve has short-term rates above those of the other time periods, while the long-term rates have yields lower than the other time periods; so the curve has certainly flattened. 

1IOTWyieldcurve

Yield Spread: As you can see above, the yield curve is made up of multiple maturity dates. To simplify the curve down to a single number, analysts often look at the difference between the two-year yield and the 10-year Treasury yield. Currently, the 10-year yield is about 1.72% and the two-year yield is about 0.80%, for a difference of 0.92% -- or 92 basis points, the lowest since November 2007.

The chart below plots the S&P 500 Index (SPX) along with this yield spread back to 1990. Just eyeballing the chart, you can see why a flat yield would be concerning. When the yield curve hits zero, stocks seem to be vulnerable to big losses. However, the last time the spread fell from a high level to below 100 basis points like now was early in 2005. There were still about three more years of gains left before the financial crisis.

2IOTWSP

Quantifying the Results: In the tables below, I quantify how the S&P 500 did over the next 52 weeks depending on the level of the yield spread. You can see I broke the returns up into five brackets. Each bracket has the same number of returns (that's why the ranges are odd numbers). Bracket No. 1 is returns after yields were the smallest and bracket No. 5 shows returns after they were the widest. The current spread is about 92 basis points, which puts it in that second-narrowest bracket when looking at the data since 2000, and technically in the third bracket when going back to 1990 -- but it's right on the cusp of the two, and it's decreasing, so I highlighted both brackets.

Looking at the data since 2000, it's clear stocks have done well when yield spreads were wide and they have done poorly when the spread is narrow. You can see why investors find it worrisome that yields are falling.

When you include the 1990s in the data, the analysis isn't as clean. In that case, the second bracket is the best-performing bracket by average return, and the third bracket is the worst bracket. So keep in mind, while the flattening yield curve is discouraging when looking at the more recent data (since 2000), when you look back over a longer time frame it's much less ominous.

3IOTWReturns

Yield Spread Falling vs. Rising: Clearly the S&P 500 has struggled going forward when yield spreads were very narrow, per the table above. And what concerns investors is that yield spreads are falling fast -- per the first chart in this article -- as narrowing spreads could indicate falling stock prices. However, does it matter whether spreads are increasing or decreasing? Using S&P 500 data since 2000, I broke down the returns in each bracket depending on whether the yield spread was falling or rising. The results are pretty interesting.

4IOTWdecreasing

When the spread is falling, like now, the average return in every bracket is positive, with at least a 64% chance of being positive one year out. In the second bracket of that first table, which is our current condition, the return over the next year averages a gain of 3.46% and is positive 66% of the time. While these returns aren't spectacular, they are a far cry from the almost 5.5% loss that occurs anytime the yield spread is in that range.

The second table shows how the index does in each of those brackets when the spread is rising. You can see the returns are absolutely awful when yields are rising up from a narrow range. So, while I can see why investors get nervous about the narrow yield spread, according to this analysis, the real danger lies when the spread bottoms and then rises through narrow levels, instead of the current situation with the spread falling toward the narrow ranges.

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