Equity market has further room to rise until yield curve inverts

THE 2s10s spread shows the difference between the 10-year treasury yield and the two-year treasury yield.

The 2s10s spread is a proxy for the yield curve, and much attention is placed on it when the 2s10s spread falls below zero because it provides a good indication of an impending recession. Historically, when the 2s10s spread falls into the negative territory, a recession tends to follow within a few months.

At the same time when the 2s10s spread is below zero, the yield curve would invert. In other words, the short end of the curve is higher than the long end of the curve, usually signalling market panic and expectations of anaemic growth in the future. Alternatively, when the 2s10s spread is negative, liquidity becomes scarce due to the unwillingness of banks to lend.

As banks borrow short and lend long, a negative 2s10s spread environment would lead to losses when the banks make a loan. Therefore, liquidity dries up when the yield curve inverts which then exacerbates the general market selloff.

Amid the interest rate hike cycle that began in December 2015 where the Federal Reserve (Fed) brought the Fed Funds Rate (FFR) up from 0.25 per cent to 0.50 per cent, the 2s10s spread began the decline lower. Since then, the Fed has hiked the FFR three more times to 1.25 per cent, leading to a lower 2s10s spread, falling from 1.24 per cent to the current low of 0.57 per cent.

There is a strong negative relationship between the FFR and 2s10s spread where the prolonged rate hike cycle inevitably leads to the inversion of the 2s10s spread. For example, the rate hike cycle in the housing boom period of the 2000s. The Fed began the rate hike cycle only in July 2004 where the FFR was lifted from one per cent to 1.25 per cent. At the same time, the 2s10s spread was still trading at a high of 1.92 per cent.

Subsequent rate hikes to 4.25 per cent in the following 17 months finally dragged the 2s10s spread into negative territory in December 2005. The Fed only realised the problem with the negative 2s10s spread six months later in June 2006 where they were forced to halt the rate hike cycle at a high of 5.25 per cent. The halting of the rate hike cycle also signalled to the market that something was amiss.

Ultimately, the market fell sharply in the latter part of 2007 as recession ensued in December 2007. Both the inversion of the 2s10s spread and the subsequent halting of the rate hike cycle provided ample warning of a major market downturn. Historically, this pattern has played out perfectly since the 1970s where:

Fast forward to today, the Fed is still well on track in their rate hike cycle. One more rate hike is expected in December 2017 according to the Fed Fund Futures implying a 98 per cent probability of a rate hike to 1.50 per cent. Furthermore, based on the Fed's dot plot projection, three more rate hikes are expected in 2018. If the Fed follows through with this projection, then the current rate hike cycle would resemble the rate hike cycle in 2004.

Using the data back in 2005 where the 2s10s spread was also trading at the current 0.61 per cent, extrapolating the pace of the decline suggests 34 weeks before the 2s10s spread drops below the danger zone of zero. Even if the 2s10s spread falls into negative territory, the fall out in the market will not be immediate. On average, recession occurs with a lag time of 54 weeks after the inversion of the yield curve.

In conclusion, we believe the equity market has further room to rise until the inversion of the yield curve happens. Our base case scenario points to a lengthy 34 weeks before the inversion of the 2s10s spread happens. All remains well for now.

Disclaimer: Chartpoint is provided by Phillip Securities Research for information only, and should not be construed as investment advice.