What's the Link Between Yield Spreads and Stocks?

A deeper dive into the historical correlation between stocks and the 2-year and 10-year yield spread

The following is a reprint of the market commentary from the June 2015 edition of The Option Advisor, published on May 21. For more information or to subscribe to The Option Advisor, click here.

"Stocks end lower amid bond volatility," USA Today, May 12
"Rise in Long-Term Interest Rates Pushes Down Market," New York Times, May 12
"Bond market volatility unsettles stocks," Financial Times, May 12
"Stocks whipsawed by rising bond yields," Chicago Tribune, May 12

Equity benchmarks around the world experienced a patch of bumpy price action in mid-May, as a sell-off in German bunds spilled over into U.S. Treasuries. Yields on both instruments jumped as prices fell, and rattled investors dumped stocks in a hurry.

On May 12 -- a day that saw the S&P 500 Index (SPX) down 0.9% at its session lows, resulting in the Greek chorus of headlines above -- the CBOE 10-Year Treasury Note Yield Index (TNX) topped out at 23.35, its highest level in nearly six months.

Chances are, you're already familiar with this type of interplay between Treasury notes and stocks. When bond prices fall, yields rise -- which translates into increased borrowing costs. Not only do higher yields diminish the appeal of investing in equities, they also raise the threat of constricted corporate spending. As a result, a sudden or unexpected rise in yields can trigger equally sudden weakness in stocks.

However, a deeper dive into the data suggests there may be more to this relationship than occasional short-lived, knee-jerk jolts. Our senior quantitative analyst, Rocky White, examined the correlation between S&P performance and the spread between 2-year and 10-year Treasury notes. As the chart below clearly displays, the market crashes in 2000 and 2008 occurred shortly after the spread hit an extreme low.

As of May 15, the spread between these notes was about 165 basis points, with the 10-year yield at 2.228% and the 2-year yield at 0.580%, according to MarketQA.To put this in historical context, the table below breaks down yield spreads into five "brackets," each tallying the same number of returns -- with Bracket 1 including the narrowest spreads, and Bracket 5 the widest. Reviewing the data back to 2000, the current yield spread is in the third quintile -- on the high end of "average," as this metric goes.

You'll also notice a column displaying the corresponding 52-week S&P returns for each of these yield-spread ranges. Over the past 15 years, stocks have performed well when yield spreads are relatively wide. Brackets 4 and 5 both reflect substantially positive average and median 52-week S&P gains, with a preponderance of positive returns. On the other end of the spectrum, Brackets 1 and 2 show the benchmark index wavering between modest gains and notable losses, with the positive and negative returns closer to parity.

A more robust lending environment is perhaps the simplest explanation for this correlation between a wider yield spread and a stronger S&P. When spreads are wide, banks that borrow at short-term rates and lend at longer-term rates experience better lending margins -- and are thus more willing to lend, given the potentially increased profits from such lending activity.When borrowing needs are more likely to be met by lenders, new projects and expansion are more likely to occur, thereby contributing to earnings growth.

Based on this historical data, it would appear that Bracket 4 is the "sweet spot" for stocks -- which means we'd want to see the spread widen from here. In fact, the direction of this indicator may be just as relevant as the absolute reading. A yield spread that rises (or widens) from a low range can be viewed as bullish for stocks, while a declining (narrower) spread can be considered a potential red flag for an upcoming period of equity underperformance.

Meanwhile, from a technical analysis perspective, traders should take note of the 320-day moving averages for both TNX -- which, as you may have gathered, proxies the yield on 10-year notes -- and the iShares 20+ Year Treasury Bond ETF (TLT), which tracks the prices of long-term bonds. Peaks in TNX have been contained by its 320-day trendline since last summer, including the pop earlier this month. On the other hand, TLT is currently finding its footing at this moving average -- setting the stage for a possible repeat of TLT's April 2014 test of support at its 320-day, which preceded a substantial 10-month advance in the shares.