Terrible Two’s?: What Surging 2-Year Yields Mean for Markets
Money is getting more expensive around the world. At least in the short term.
Over the past couple of weeks, we have seen an incredible surge in 2-year government bond yields across major economies (see chart page at the end of the update).
With this rise in 2-year yields, there is a clear message that the rates market is sending: the market believes that global central banks are going to have to raise rates in order to keep inflation under control.
After over 18 months of ultra-loose monetary policy, the surge in 2-year yields says we are now in a new phase of monetary policy tightening.
What Does The 2 Say?
It is helpful to refresh a couple of points on short term yields:
The 2-year yield is most sensitive to expectations about future central bank policy. A rise in 2-year yields often precedes the start of a tightening cycle.
In Chart 1 we show this dynamic in the U.S., with the gray bars indicating the start of tightening cycles. As the bond market reads the tea leaves of macro data (such as elevated inflation) and Fed signaling, it starts to push 2-year yields higher as rate hikes to become more certain.
The same is true in the opposite direction when the market senses that the Fed has gone “too far” in tightening (often when the yield curve inverts, meaning the yield on 2-year debt is higher than the yield on 10-year debt), the market pushes 2-year yields lower, in anticipation of rate cuts coming soon.
So as we see 2-year yields rise around the world, it is a signal that we are now in a period of monetary policy tightening, compared to the aggressive monetary policy easing we have experienced in the last 18 months.
Also notable, the recent 6-month change in the U.S. 2-year yield is the largest on record going back to the 1970s (it is easy to have such a large percentage change coming off of a low base, which is one display of the after-effects of financial repression).
Curve’s the Word, Flat’s the Verb
At the same time, we are seeing higher 2-year yields in the U.S., we are also seeing falling 10-year yields. This signals that the market expects lower growth and inflation in the out years, given tighter policy in the near term (there are of course other factors at play with 10-year yields dropping, like technical supply and demand).
The end result of higher short-term rates and lower long-term rates is a flattening of the yield curve. We can see this in Chart 3 with the triangle line showing today’s yield curve being flatter than the yield curve six months ago.
One of the most-watched relationships on this yield curve is the 10-2 spread that we mentioned above (Chart 4). Normally the 10-year yield is above the 2-year yield. But when this relationship flips and the 2-year is higher than the 10-year, it is a sign that the bond market sees policy as too tight for the underlying economy, raising recession risks.
The size of this spread is also an indicator of how far the Fed can move to tighten policy: once the 10-2 curve falls too far near zero, any further tightening by the Fed risks threatens curve inversion and even recession (which also sparks risk asset price volatility).
We have noted multiple times since the spring that the 10-2 curve typically peaks ~250 bps, but this cycle peaked at only ~150 bps in March 2021. At only 107 bps today, the 10-2 curve affords much less runway for the Fed to raise rates this cycle. The Fed currently has a 2.5% target for the long-run Fed Funds policy rate (its return to “normal”), but we think it will be difficult to reach that level given the shape of the curve at just over 100 bps today.
What This Means for Equities
All while this short-term yield increase and curve flattening are happening, the U.S. large-cap equity market continues to trade to all-time highs. So, are equities impervious to a coming tightening cycle?
Initially yes, then just on the surface yes, but then no.
Equities can continue to rally and reach new all-time highs on an index level as policy first starts to tighten. This is because as tightening begins, the underlying economy often remains strong, allowing the central bank to remove policy support. Strong economic growth also drives continued earnings growth.
As policy continues to tighten and 2-year yields continue their ascent, we start to see a few things happen with equities. The pace of the rally tends to slow, valuation multiples tend to struggle to expand further as liquidity contracts, and the rally becomes more narrow (in favor of idiosyncratic growers and higher quality names as tighter liquidity weighs on economic growth and raises funding costs). This tends to be associated with being in the later stages of the “mid-cycle”. This is the stage we think we are entering as we near 2022.
As this process continues, the yield curve becomes the vital indicator for how the bond market views policy tightness in relation to economic growth.
Once the yield curve flattens materially, indicating policy is becoming too tight amidst economic slowing, we start to see more defensive leadership emerge in equities. This is consistent with being “late-cycle”. Defensive outperformance is often a harbinger of larger equity volatility and drawdowns to come.
In the past, this has meant outperformance in areas like Staples and Utilities that have very stable earnings. This defensive leadership may look different in the next cycle given ESG considerations for Utilities and the emergence of stable cash flow tech leaders. Regardless, we will still be on the watch for signs of classic defensive leadership to indicate we are late-cycle (mostly given how flat the curve already is). We are not seeing defensive leadership yet, with Utilities not signaling any turn in performance, hovering near relative cycle lows versus the S&P 500 last week (Chart 4).
Financial Conditions: Still Near Record Loose, Can it Sustain?
One interesting point to note is that financial conditions, despite the rise in short-term yields, remain extraordinarily loose. The Goldman Sachs Financial Conditions Index (GSFCI) remains near record lows (low is loose, high is tight) reached in September of this year (Chart 5).
To look at GSFCI is a signal for future movement in risk assets like equities and credit is a circular reference because the index itself includes equity performance and credit spreads as inputs. However, with this index remaining near all-time loose levels, it indicates that short-term rates moving higher have not yet been enough to tip the index into a tightening trend. This is due to continued strength in equities and credit, but also that long-term real rates remain deeply negative.
This will be a very important watch item as we go into 2022. The last times we saw financial conditions tighten during an economic expansion we saw cyclical assets underperform, along with lower equity multiples and choppier equity trading (think 2014-2015 and 2018).
The rise in 2-year yields does not seem to be a problem for equity markets yet.
The “Santa Claus”/strong seasonal rally looks to have taken hold, propelling stocks higher into year-end.
As we move into 2022 and the tightening cycle comes more into focus, we expect to start to see the slowing and narrowing of the equity rally start to take shape. We’ll watch for early signs of this in financial conditions tightening, with more nefarious indicators being defensive sector outperformance.
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