Widening Yield Curve Could Be A Mixed Blessing for Stocks

The widening gap between short- and long-term interest rates is normally good news for stocks. But worries about huge government deficits are tempering some of the enthusiasm.

A trader at the New York Stock Exchange.
Photo: Oliver Quillia for

The spread in long and short rates, known as the "yield curve," is currently about 366 basis points—or more than 3 1/2 percentage points—the biggest it's been in decades.

A gap that size indicates that investors are anticipating economic growth and don't want to tie up their money for long periods of time. Investments with longer maturities then have to offer a higher rate to boost demand, and the resulting gap is seen as a bullish sign for stock investors.

Yet investors also are becoming worried about massive government spending that could jeopardize the economic recovery and buck the trend of a wide rate spread being strongly positive for stocks. In that scenario, the higher yield for longer investments would be seen as a sign of runaway inflation. Stock investors like some inflation, but not too much.

In light of such concerns, some advisors are encouraging a use of hedging techniques, as well as stocks in areas such as health care and technology that are less dependent on economic vagaries.

"Given what we've just been through the last two years, if it were going to be different, now would be the time," says Nicholas Colas, chief market strategist at CovergEx Group. "Investors are fundamentally worried about the US ability to fund budget deficits in 2010. From an investment perspective you've got to be very defensive, because the long end of the curve still has higher to go."

Indeed, there remain concerns that the 30-year Treasury bond specifically hasn't seen its high point in yield. While aversion to the long bond has so far coincided with a sustained positive run for stocks, Colas worries that fears over future are nearing a point that become negative for the markets.

A poorly received Treasury auction last week for the 30-year seemed to reflect that concern. Stocks, meanwhile, have experienced a sluggish time this week, with the Dow slipping modestly as investors seem undecided about the ramifications of monetary policy.

"If you really believe the economy is on the solid path to recovery, the yield curve is flashing the most vibrant green light you would want to see," Colas says. "I appreciate the yield curve is flashing a very positive sign for equities. My argument is you should hang out for a little. Don't get pulled in right now."

Colas is not advising investors out of stocks, but is encouraging ETF plays that hedge against further growth in the yield curve.

Among his recommendations are the ProShares Ultra Short 20+ Year Treasury , which pays double the inverse return of long-term bonds; and the Direxion 30-Year Treasury Bear, which pays three times the inverse of the long-bond's price performance.

In times of economic growth investors will shy away from longer-dated debt such as 10-year notes and the 30-year bond on fears that their money will be worth less over the long term.

They'll switch instead to two-year notes to protect principle and to stocks to gain returns. As a result, the spread widens between short- and long-dated notes—in this case reflecting the widest spread between two- and 30-year debt in at least 30 years.

Economists believe the trend will stay in place for at least well into 2010, due also to help from the Federal Reserve.

"With the Fed saying they're on hold for an extended period of time, that's what's keeping the curve steep more than anything else," says Tom Higgins, chief economist at Payden & Rygel in Los Angeles. "The market probably likes the idea that the Fed is going to keep rates on hold for an extended period of time."

But there's worry over what the long-term ramifications could be.

"Unless and until the Fed tries to take the punch bowl away, a widening curve—as long as the pain is not too acute in terms of the 30-year bond—can be bullish for equity prices because it can signal an expansionist monetary policy," says Mike Larson, an analyst at Weiss Research. "There is a point where if bonds start falling fast enough it goes from a neutral-to-positive to flat-out negative."

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Investment mangers mindful of such a possibility are using other strategies as well to shield investors from the dangers of overly accommodative monetary policy that could mask the dangers of a gaping yield curve.

Rob Williams, director of fixed income planning at Charles Schwab, is advising clients to hold a mixed bag of bonds that straddle the line between needs for principle and desire for higher yields.

"We've been suggesting a balance with not too much exposure to really long-term bonds unless investors know they want to have higher income and they plan to hold to maturity," Williams says.

"Somewhere in there is a balance between risk and reward that benefits from a steep yield curve and the risks of not earning anything if you're investing in cash," he adds. "For investors interested in income we've been encouraging a balance between five and 10 years on average, with cash set aside as well for shorter-term bonds for money you know you'll need right away."

As for investors who see mostly strong positives from the yield curve, Paul Quinn, an advisor at Focalpoint Capital Management in Bozeman, Mont., recommends stocks in areas such as health care and technology that will benefit from future trends.

Quinn says the triple-threat of an inverted yield curve, extreme deflation and overly inflated stock prices almost always portends recession—and none of those three qualities are present now.

"You just don't fight the Fed. If they're going to maintain rates artificially low it's only going to stoke the equity markets," he says. "The danger as investors is in being on the sidelines."