Since the summer of this year, a remarkable shift has occurred in the yield curve of U.STreasuries, with the yield on the 10-year bond rising nearly 60 basis points over the 2-year bond, moving from an inverted state to a steeper upward slopeThis significant change can be attributed to the rise in long-term bond yields, creating a trend colloquially known as a "bear steepener." This term refers to a situation where the overall yield curve rises, suggesting that while short-term outlooks may remain bleak, long-term prospects are improving.
Historically, periods classified as "bear steepeners" have aligned with strong stock market performance, as they often indicate an improvement in growth prospectsDuring such times, cyclical stocks—those that perform well when the economy is doing well—along with small-cap and value stocks, typically thrive
In stark contrast, long-term growth and defensive stocks generally struggle to keep pace.
Nevertheless, an essential distinction arises when a "bear steepener" is incited by rising real interest rates as opposed to increased inflation expectationsIn such cases, the stock markets tend to grapple with challenges, and cyclical stocks may fail to outperform the broader market, while value stocks continue to surpass growth stocks.
It should be underscored that whether the impetus for the current bear steepening is from real interest rates or inflation expectations, its impact on the stock market and cyclical assets could be detrimentalThe current concern is that, following the global financial crisis, conditions have reversed, leading to a stock market and cyclical assets downturn as yields riseThe most apparent vulnerabilities appear in sectors with considerable leverage—specifically, real estate, utilities, small-cap stocks, and firms with weak balance sheets
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Hence, should borrowing costs escalate further, companies with healthier financial positions will likely find themselves in more advantageous positionsIn this environment, industries such as healthcare and technology remain recommended, while sectors like banks and energy may outperform.
"Bear steepener" typically favors cyclical and value stocks
Typically outperforming the market
Research indicates that the overwhelming majority of periods defined as "bear steepeners," where long-term interest rates rise, have occurred after the global financial crisisKey instances in the U.Ssince 1990 mark these events in 2010, 2013, 2015, 2016, 2021, and this summer.
The current bear steepener seems initially driven by surging growth expectations, but it has increasingly been influenced by both rising real interest rates and inflation fears
During such phases, equity markets traditionally perform robustly, as scant historical examples suggest that improvements in key economic indicators like ISM and GDP growth forecasts typically characterize these situationsIn stark contrast, in "bull steepener" episodes—characterized by falling short-term rates—the stock market tends to falter, as it often aligns with central banks being compelled to lower rates amid looming recessions.
Accordingly, in "bear steepener" environments, cyclical stocks tend to outshine defensive and small-cap stocks, while value stocks typically outperform growth counterparts.
The driving forces behind the "bear steepener"
Clearly affect different sector performances
However, a crucial nuance to note is the role of rising real interest rates
When a bear steepener stems from this factor, the equity market often encounters difficultiesAlthough most bear steepeners arise from heightened inflation expectations, approximately 25% of these situations are prompted by rising real interest ratesSignificant cases in history include the bear steepeners of 1997, 2003, and 2013, all of which were driven primarily by real interest rate increments.
In these instances, sector performance indeed exhibits marked volatilityFor example, when the rise in real interest rates leads to a bear steepener, sectors such as telecommunications, healthcare, pharmaceuticals, and utilities typically showcase resilienceHowever, when rising inflation expectations trigger bond sell-offs, these sectors often exhibit underperformance.
Conversely, cyclical sectors generally falter during bear steepeners driven by real interest rates, yet they flourish when inflation expectations are the primary factor
This insight suggests that sectors associated with construction materials, travel and leisure, automotive, and commodities typically suffer in scenarios where the bear steepener is engendered by rising real rates, while they tend to excel in environments driven by increased inflation expectations.
This relationship is intuitive for many firms in these industriesNumerous companies within the construction materials sector closely follow trends in inflation ratesOn the flip side, surging inflation expectations often accompany rising energy prices, providing a boon for energy and basic materials companies.
This bear steepener might negatively affect
markets and cyclical sectors
We possess multiple reasons to believe that whether driven by real interest rates or rising inflation expectations, this bear steepener could ultimately be harmful to the stock market and cyclical sectors.
Firstly, the increase in bond yields does not necessarily denote robust growth prospects; rather, it reflects growing fears over rising inflation
Concerns about higher public debt levels potentially leading to bond over-supply weigh heavily on investorsNevertheless, on a more optimistic note, advancements in artificial intelligence could yield productivity growth and bolster investment demand, which differs from conditions experienced during historical bear steepeners post-2008 crisis when rates were at all-time lows, and increases were perceived as signals of improving growth expectations.
Secondly, the current level of interest rates has surged to record highs, reaching 4% to 5%, and any further increases will apply significant pressure on both the stock market and cyclical assetsMeanwhile, stock valuations appear less compellingThe equity risk premium has dwindled to 4%, marking a 15-year low, signaling that equities present less buffer against the impact of soaring interest rates.
Since the bear steepener, U.S
stocks have declined by 8%
The healthcare sector has outperformed
Following the bear steepener in late July, the stock market has plummeted by 8%. Particularly, the healthcare sector has excelled relative to othersYet, utility companies have demonstrated a marked underperformance, possibly reflecting escalating concerns regarding rising debt costsMeanwhile, since that time, value stocks have outstripped growth rates by 5%, although cyclical sectors have lagged behind defensive sectors by 2%.
What would happen if the yield curve shifted into a "bull steepener," characterized by declining short-term rates? Historically, bull steepeners have represented some of the worst environments for stock markets, as they frequently align with increased recession risks and central banks unwittingly lowering rates.
Nonetheless, stock market performance also hinges on the underlying reasons for falling short-term rates.
When the decline in short-term rates is primarily driven by real interest rates, equity markets perform commendably, with monthly increases averaging 1.6% as cyclical stocks outshine