Isaac Newton sure was on to something with that whole First Law of Motion thing: Trends in motion tend to stay in motion.
And no trend has been more enduring and powerful since early 2004 than the flattening of the yield curve, a topic last addressed here in
The rapidity and power of the yield curve changes over the past five years is difficult to comprehend.
conducted a great experiment in driving short-term interest rates lower between 2001 and 2003. The yield curve steepened under this monetary onslaught; long-term rates didn't tumble as much as the market began pricing inflation into the mix.
Once this experiment ended, the flattening of the yield curve that's still under way proceeded, as Newton would have predicted, in an equal and opposite fashion.
We can illustrate this with the forward-rate ratios between various points on the yield curve. The forward rate between, say, two and 10 years is the rate at which you can borrow money for eight years beginning two years from today. If the ratio between this forward rate and the 10-year rate itself exceeds 1.00, the yield curve is positively sloped. Levels less than 1.00 indicate an inverted yield curve.
Incredibly, there are people who can look at the chart below and debate when we're headed for an inversion.
Here's some free advice: When you fall out of a window, skip the debate on whether you'll hit the ground or not. Newton had that gravity thing down, too.
Get Ready to Invert
Europe Joins the Party
Jean-Claude Trichet of the European Central Bank, possibly motivated by my merciless taunting
two week ago -- I'm certain he had to answer for my "
" gibe -- made it clear this past Friday that short-term interest rates were going to rise in the eurozone. Interestingly, the bond market in Europe began pricing in a flatter yield curve at the end of March 2004; the forward rate ratio for European sovereigns over the two- to 10-year segment has been flattening and flattening at an accelerating rate since then.
We can make no parallel statement for the six- to nine-month segment of the yield curve, the money market segment related most directly to the currency market. This has been moving both in a steepening and flattening fashion regardless of official ECB policy and in a manner unrelated to longer segments of the yield curve. It should be safe to assume the European money market curve will flatten as ECB policy tightens, but you would be amazed to learn what Isaac Newton had to say about "assume."
Euro Yield Curve Has Been Flattening at Long End
Flat Curve Winners and Losers
Let's return to an analytic technique first introduced here in
February and used several times since, that of measuring the relative impact of a market factor on industry groups.
Negative numbers in the table below indicate groups benefiting from or at least not hurt by the flatter yield curve, while positive numbers indicate groups hurt by the flatter curve. The groups with statistically significant relationships (90% confidence interval) against the large-cap
, the mid-cap S&P 400 and the small-cap S&P 600 are displayed.
The list of victims is pretty clear across market capitalization levels. Utilities, REITs, oil-related groups, pharmaceuticals and financial firms, particularly thrifts and mortgages, should underperform by virtue of the flattening curve. Relative winners are in the technology sector, especially semiconductors and software, and in electrical goods manufacturing.
This list of winners and losers relative to the forward rate ratio is not significantly different from the one posted in May. As the forward rate ratio between two and 10 years has declined from 1.02818 to 1.00578 during the interim, let's see how effective the relative performance signals were.
For this exercise, we will combine all of the S&P indices into the S&P 1500 Supercomposite. The total return of each industry group over the six months since May will be multiplied by the group's weight in the Supercomposite. Only a handful of groups had capitalization-adjusted returns of less than a -.05% contribution to the index's total return of 6.86% over this period. Three of these underperformers -- pharmaceuticals, packaged foods and thrifts and mortgages -- were expected to be affected negatively by the flatter yield curve, and they were. Pharmaceuticals in fact had the worst total return times capitalization product of any group: -0.59%.
If we move outside of the zone of underperformance, the picture starts to change. The chart below depicts the groups' whose capitalization-weighted total returns exceeded 0.05%. They are color-coded as black for basic materials, violet for utilities, turquoise for information technology, green for financials and red for energy. All others are colored white.
Capitalization-Weighted Six-Month Total Return
We expected the technology groups to slough off higher interest rates, a stronger dollar and a flatter yield curve -- and this certainly was true for computer hardware, communications equipment, system software, data processing and outsourcing, and semiconductors.
But what about the oil-related groups? These were expected to be affected negatively by the above-named factors, and yet their performance topped the charts. Here the answer is obvious: The financial factors affecting the oil-related issues negatively simply were overwhelmed by the unprecedented gains in crude oil, natural gas and refinery margins. Other executives might kill to have profits gaudy enough to be dragged up to Capitol Hill for a tongue-lashing.
The performance of the financial issues is fascinating. It was taken as gospel for years that this sector was one giant "carry trade" whose profits were generated from borrowing at the short end of the curve and ending at the long end of the curve. But these are not your father's financials; they make money more on trading, fees, prime brokerage and other services unrelated to the yield curve. Who knows how strong their performance would have been in the absence of the recent flattening of the curve?
Newton had one last relationship figured out: Force equals mass times acceleration. The large mass of the combined financial and energy sectors is being affected by an accelerating flattening trend both in the U.S. and in the eurozone. That force is being resisted and indeed pushed back by profit growth elsewhere and by increased risk acceptance. But it is there, pushing toward us. Just because it hasn't ruined anything yet doesn't mean it's incapable of doing so.
Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of
The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback;
to send him an email.
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