Inside Markets — Yield Curve

The yield curve steepening that’s occurred over the last two months has mostly been driven by lower short-end rates.  Longer-dated yields have also declined but by a lesser degree. This type of curve steepening does NOT deliver cyclical sector outperformance.  Sharply lower short-end yields and slightly lower long-term yields are a disinflationary signal and potential recession warning with defensive sectors as primary beneficiaries. This explains some of the recent outperformance in Utilities, Telcos, Staples and REITS.  We expect more near-term outperformance from these groups with the addition of Health Care that has thus far lagged.  Pure cyclical beneficiaries like Energy, Materials (mining and chemicals) have underperformed along with cyclical consumer areas like autos, airlines and travel/leisure.  Cyclical groups outperform when the curve steepening is driven by lower short-end yields and static/rising longer-dated yields.  Again, that is NOT the case at the moment.  Small-cap stocks usually benefit from this latter form of curve steepening, but we think they have a chance to outperform on a relative basis in the current environment.  This is because small-cap stocks have been disproportionately punished by the rising cost of capital over the last 2 years.