By: Steve Sosnick, Chief Strategist at Interactive Brokers

In the first quarter, 10-year yields rose by about 80 basis points. But wait, am I talking about the current situation or last year? In actuality, I’m talking about both.

Indeed, 10-year yields moved sharply higher in the first quarter of last year just as they have in the current quarter that ends tomorrow. Consider the moves in the two graphs below:

US Treasury 10-Year Yields, Q1 2022, with 30 Day Moving Average

Source: Bloomberg

US Treasury 10-Year Yields, Q1 2021, with 30 Day Moving Average

(Click on image to enlarge)

Source: Bloomberg

We see that the magnitude of the yield moves in each of these three-month periods is quite similar. Yet the circumstances behind those moves is vastly different. One year ago we were in the midst of unprecedented monetary and fiscal stimuli, and the bond market was expressing fears that the expansionary policies could lead to inflation down the road. Before we applaud bond traders for getting that call correct, bear in mind that yields peaked at the end of March 2021. Long rates headed lower when it appeared that the economic expansion was not creating immediate inflation. Inflation eventually arrived, but 10-year yields had reverted to below 1% by then. (Quantitative easing, which involved buying bonds, certainly helped push yields lower.) It was from that low base that we saw the current bump in rates.

The key differences between now and last year are revealed when we compare the spreads between 2- and 10-year notes then and now:

Yield Spread between US Treasury 2- and 10-Year Notes, Q1 2022, with 30 Day Moving Average

(Click on image to enlarge)

Source: Bloomberg

Yield Spread between US Treasury 2- and 10-Year Notes, Q1 2022, with 30 Day Moving Average

(Click on image to enlarge)

Source: Bloomberg

The first of the two graphs above shows that the 2-10 spread has collapsed this year while the second shows that the spread widened last year by roughly the same amount that 10-year rates rose. The implication in the latter example is that 2-year rates stayed stable as 10-year rates rose. The former graph implies that 2-year rates rose even faster than 10-year rates – about twice as fast in this case. In other words, we saw the yield curve steepen dramatically last year and flatten just as dramatically this year. If you look really closely at the Q1 2022 graph you might be able to see yesterday’s momentary yield curve inversion.

The messages sent by the yield curve cannot be more starkly different. A steepening yield curve implies economic expansion, accompanied by an accommodative central bank and low inflation. That proved to be the case for most of last year, which proved to be a banner one for most risk assets. A flattening curve or heaven forbid an inverted one, implies that a slowing economy or even a recession is even on the horizon amidst central bank tightening. If the steeper yield curve led to an excellent climate for risk assets, by implication a flattening or inverted curve represents a real challenge for stocks and the like. The following charts show the dichotomy:

S&P 500 (SPX) Daily Candles, Q1 2022, with 30 Day Moving Average

(Click on image to enlarge)

Source: Bloomberg

S&P 500 (SPX) Daily Candles, Q1 2021, with 30 Day Moving Average

(Click on image to enlarge)

Source: Bloomberg

In 2021, SPX trended higher (as shown by the green moving average line) with modest volatility. This year, stocks trended generally lower with high volatility. The recent bounce also reflects volatility, just the more “socially acceptable” kind. 

It remains to be seen whether the current rally represents a meaningful turning point or simply a bear market rally. If it proves to be a bear market rally, it certainly fits in with the typical “short, sharp, and ferocious” rubric. My inclination is to infer that the bounce was more the result of technical and timing factors rather than a paradigm shift. I believe that institutions were raising cash from January through mid-March, as central bank headwinds and geopolitical tensions raised angst among portfolio managers. Throughout that period, individual investors who have become conditioned to and generally rewarded by buying dips continued to keep the faith. Just before the FOMC meeting two weeks ago, many institutional investors recognized that equities had become somewhat oversold. As the market bounced, those institutions realized that they were holding too much cash in a bouncing market ahead of a quarter-end reporting period. Asset allocators continued to sell fixed income, but the proceeds have been more aggressively deployed into equities in recent weeks. 

We are seeing the real-world test of my hypothesis now. If much of the recent rally was driven by institutions that wanted to replace idle cash with equities on quarter-end reports, they would have needed to finish their buying yesterday. That was the last date on which trades would settle before quarter-end. The spike higher at the end of yesterday’s session and the modest declines this morning fit into that hypothesis. The hypothesis still holds up if we see some window dressing tomorrow afternoon, but we won’t really know for sure until next week. It will be fascinating to see if we see assets get reallocated into underperforming fixed income if cash holdings rise, or stocks continue their advance.