Tech stocks got clobbered in New York on Tuesday after Treasury Secretary Janet Yellen said, “It may be that interest rates will have to rise somewhat to make sure our economy doesn’t overheat.”
Tech stocks, as everyone knows, have traded in a straight line with interest rates for the past year (that is, with a 95% regression fit to the 5-year inflation-indexed Treasury yield).
Bank stocks, though, trade with the difference between short-term and long-term interest rates. (That’s because banks borrow short and lend long.)
The Chart of the Day shows the close relationship between the slope of the yield curve (the difference between 10-year and 2-year Treasury yields) and the S&P bank index.
More inflation means a steeper yield curve: The market will conclude that inflation isn’t “transitory,” as Yellen and the Federal Reserve say, but persistent, and will demand higher compensation for buying bonds of longer maturity. In addition, the market will assign a higher probability to future rate increases.
If and when the Fed raises short-term rates, the curve will flatten. But the the Fed won’t do that for the foreseeable future – not when the US government has a multi-trillion-dollar deficit to finance.
The Fed wants the yield curve to steepen. That encourages banks to buy more Treasury securities, because the higher yields on longer maturities can be funded with cheap short-term money.
The chart above shows the slope of the Treasury yield curve compared with the year-on-year percent change in bank holdings of government bonds. When the curve steepens, banks usually tend to buy more Treasuries. (How much they buy also depends on whether businesses want loans, which are more profitable for banks than Treasuries.)
Over the past 12 months US banks bought almost a trillion dollars’ worth of Treasuries, which sounds like a lot until we remember that the Fed itself bought $4 trillion worth. Still, the banks are the only big buyer in the market apart from the Fed.
That’s why I think the yield curve will steepen further: Higher inflation means a steeper curve, and the Fed has no motive to try to stop this.
That could be very bad for tech stocks. But it’s an ill wind that blows no stock good, and bank stocks are likely to outperform the market in a steepening curve environment.
Of course, you could just sell 10-year notes and buy 2-year notes, but most individual investors don’t feel comfortable in that sort of trade. Besides, it would cost you about 1.5 percentage points in negative yield to do so (because 10-year Treasuries yield 1.5 percentage points more than 2-year notes). Bank stocks pay dividends.