Weekly Chart: SP500 vs. US 2Y10Y Yield Curve

Historically, research has shown that the difference between long-term and short-term interest rates (‘Yield Curve’ or ‘Time Spread’) has shown some significant negative relationship with subsequent real economic activity in the United States, with a lead of about four to six quarters. Hence, with the current low levels of the US yield curves (2Y10Y or 5Y30Y), we chose today this week to overlay the 2Y10Y yield curve with the SP500.

If we say that low yield curves tend to predict recessions, then the question now relies on quantifying a low level of the yield curve. We hear from many analysts that the current levels are very low, however if we look back at 40 years of data, the US yield curve levels are not that far away from their long-term averages. For instance, the 2Y10Y and 5Y30Y slopes are currently trading at 51bps and 53bps, while their LT averages stand at 95bps and 82bps, respectively (see here). One main reason why yield curves have been crashing over the past few months is mainly due to an increase in the front-end of the US curve on a back of a shift in expectations of monetary policy. The US 2Y interest rate is now trading at 1.96%, its highest level since September 2008. On the other hand, the 10Y yield stands at 2.46%, has been ranging between 2% and 2.6% over the past year and is up 110bps from its historical low of 1.36% reached in July 2016.

The chart below shows the importance that even if the yield curve turns negative in the US, the equity market has still upside potential in the following months. In our first observation, the 2Y10Y time spread went negative in February 2000, while the SP500 continued its rally and reached a peak in September the same year. In the second one, the yield curve inverted in June 2006 (if we ignore the Jan-Mar 2006 episode) while equities continued to rise for more than a year, peaked in October 2007, and the US plunged into the Great Depression in December 2007.

We don’t think that the current levels of the yield curves are actually alarming for the US economy and we may see a potential floor in the first quarter of this year as we believe that market participants’ (over)excitement on the Fed potential hikes will ease in the medium term. The probability of 4 or more hikes has soared to 12.1%, which pushed the front end of the US curve on the upside and explains the sharp flattening we saw in 2017 (from 1.27% to 0.5%). However, if we look at the EuroDollar futures market, the December 2018 contract currently trades at 97.81, suggesting that investors are pricing in a ST interest rate of 2.19% by the end of the year (see here). This analysis also confirms our bearish view on the US Dollar for 2018 (especially against the Euro).

Chart: SP500 (yellow, rhs) vs. US 2Y10Y Yield Curve (Source: Reuters Eikon)

Yield Curve.PNG

Weekly Chart: US 2Y10Y yield curve vs. USDJPY

Among all the potential compatible candidates that show an interesting correlation vis-à-vis the USDJPY (i.e. 10-year US-Japan interest rate differential, Topix index …), I chose this week to overlay the currency pair with the US 2Y10Y yield curve. If we look at the past three years of data, we can notice an interesting development that has started since mid-April of this year. While the US yield curve and USDJY has shown strong co movement between January 2015 and April 2017, it has been a different story over the past 8 months.

In the US, the yield curve has constantly been falling and is currently trading at 51.5bps half the value where it was sitting in April 2017. On the other hand, the Japanese Yen has been oscillating within a 7-figure against the green back, between 107.50 and 114.50. What is interesting about this divergence is that it started more or less at the same time of the Topix vs. USDJPY divergence, with Japanese equities soaring from 1,500 to 1,800 and a Yen mean reverting around 111 against the USD ( see tweet Topix vs. USDJPY).

The question now is: How long can this divergence persist in the near to medium term? The current level of the US yield curve has raised the concern of many market participants as in theory it is viewed as a strong predictor of future recessions. Looking at economic and financial data, I don’t personally believe that we are very close to a potential recession in the US; in addition, the yield curve is still far from its extreme lows of -20bps and -95bps we saw in November 2006 and May 2000 (if we just look at the past 30 years of data). However, I think that we may see some US Dollar weakness against the Japanese Yen, on a back of slowly disappointing fundamentals (easing all the excitement on the expected Fed rate hikes) and geopolitical uncertainty. Moreover, the Japanese Yen is 26% ‘undervalued’ relative to its 23Y average of 99.3 according to the real effective exchange rate ( see JPY REER).

Chart: USDJPY (Candlesticks, rhs) vs. US 2Y10Y yield curve (Source: Bloomberg)

JPY US Curve