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Why Markets are Worried About the Yield Curve

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Why Markets are Worried About the Yield Curve

Explainer: Why Markets are Worried About the Yield Curve

If you pay any attention to financial media, chances are that you’ve heard increased chatter about the flattening “yield curve” in the past few weeks.

For professional investors, talking about the yield curve is close to second nature – but to most regular folks, the words probably sound very abstract or esoteric.

What’s a Yield Curve?

The yield curve is a curve showing several yields or interest rates across different bond contract lengths.

In a normal credit environment, the premise is that yields are higher for longer maturity bonds.

Normal Yield Curve

In a way, this is similar to what you’d expect if you went to the bank and put your money into a time deposit. For example, if you put your money in for five years, you’d expect a higher return per year than if you put your money in for six months.

Why? You’re taking on more risk, and therefore deserve a higher rate of compensation.

Out of Whack

Sometimes the market gets out of whack, and yield curves do some interesting things.

Yield Curve Inversion

As you can see above, sometimes long-term interest rates can be equal to those of short-term rates. This is called a “flat” yield curve.

Or, when long-term rates fall below short-term rates, that is an “inverted” yield curve. As you’ll see shortly, this can be a signal of trouble in credit markets and the greater economy as a whole.

The Curve Everyone is Talking about

While a yield curve can be shown for any bond, there is one particular yield curve that you’ll often see referenced by financial journalists and analysts.

That would be the yield curve for U.S. Treasuries, the bonds issued by the U.S. federal government to fund its activities. More specifically, the difference between 10-year and 2-year bonds has been a historical indicator of the health of the economy and markets.

And despite this curve looking pretty normal since the financial crisis, it has been flattening over time:

2-yr3-yr5-yr7-yr10-yrDifference (10yr - 2yr)
20140.54%1.02%1.72%2.16%2.48%1.94%
20150.74%1.05%1.53%1.92%2.20%1.46%
20160.74%0.86%1.12%1.39%1.54%0.80%
20171.27%1.38%1.63%1.88%2.05%0.78%
20182.64%2.71%2.76%2.83%2.88%0.24%

Source: U.S. Treasury Dept (Each year’s data corresponds to this day in September)

In 2014, the difference for 10-year and 2-year bonds was 1.94%. Today, the difference is just 0.24%!

Why It Matters

There are various interpretations out there of what an inverted yield curve could mean for markets.

There are also pundits out there who say things are different this time around. There is some validity to this, as things are never cut and dry in economics. Besides, this wouldn’t be the first time that global credit markets have acted in strange ways since the crisis.

That all said, the reason the inverted yield curve is a topic of conversation is simple: inverted yield curves have preceded every post-war U.S. recession.

So now you know what the fuss is about – and maybe, just maybe, you’re more inclined to dive deeper into the exciting world of yield curves.

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Markets

Beyond Big Names: The Case for Small- and Mid-Cap Stocks

Small- and mid-cap stocks have historically outperformed large caps. What are the opportunities and risks to consider?

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A line chart showing the historical return performance of small-, mid-, and large-cap stocks.

 

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The following content is sponsored by New York Life Investments
An infographic comparing low-, mid-, and large-cap stocks, including an area graph showing historical returns, a bubble chart showing how much $100 would be worth over 35 years, a horizontal bar graph showing annualized volatility, and a line graph showing relative forward price-to-earnings ratios, that together show that mid-cap stocks present a compelling investment opportunity.

Beyond Big Names: The Case for Small- and Mid-Cap Stocks

Over the last 35 years, small- and mid-cap stocks have outperformed large caps, making them an attractive choice for investors.

According to data from Yahoo Finance, from February 1989 to February 2024, large-cap stocks returned +1,664% versus +2,062% for small caps and +3,176% for mid caps.  

This graphic, sponsored by New York Life Investments, explores their return potential along with the risks to consider.

Higher Historical Returns

If you made a $100 investment in baskets of small-, mid-, and large-cap stocks in February 1989, what would each grouping be worth today?

Small CapsMid CapsLarge Caps
Starting value (February 1989)$100$100$100
Ending value (February 2024)$2,162$3,276$1,764

Source: Yahoo Finance (2024). Small caps, mid caps, and large caps are represented by the S&P 600, S&P 400, and S&P 500 respectively.

Mid caps delivered the strongest performance since 1989, generating 86% more than large caps.

This superior historical track record is likely the result of the unique position mid-cap companies find themselves in. Mid-cap firms have generally successfully navigated early stage growth and are typically well-funded relative to small caps. And yet they are more dynamic and nimble than large-cap companies, allowing them to respond quicker to the market cycle.

Small caps also outperformed over this timeframe. They earned 23% more than large caps. 

Higher Volatility

However, higher historical returns of small- and mid-cap stocks came with increased risk. They both endured greater volatility than large caps. 

Small CapsMid CapsLarge Caps
Total Volatility18.9%17.4%14.8%

Source: Yahoo Finance (2024). Small caps, mid caps, and large caps are represented by the S&P 600, S&P 400, and S&P 500 respectively.

Small-cap companies are typically earlier in their life cycle and tend to have thinner financial cushions to withstand periods of loss relative to large caps. As a result, they are usually the most volatile group followed by mid caps. Large-cap companies, as more mature and established players, exhibit the most stability in their stock prices.

Investing in small caps and mid caps requires a higher risk tolerance to withstand their price swings. For investors with longer time horizons who are capable of enduring higher risk, current market pricing strengthens the case for stocks of smaller companies.

Attractive Valuations

Large-cap stocks have historically high valuations, with their forward price-to-earnings ratio (P/E ratio) trading above their 10-year average, according to analysis conducted by FactSet.

Conversely, the forward P/E ratios of small- and mid-cap stocks seem to be presenting a compelling entry point. 

Small Caps/Large CapsMid Caps/Large Caps
Relative Forward P/E Ratios0.710.75
Discount29%25%

Source: Yardeni Research (2024). Small caps, mid caps, and large caps are represented by the S&P 600, S&P 400, and S&P 500 respectively.

Looking at both groups’ relative forward P/E ratios (small-cap P/E ratio divided by large-cap P/E ratio, and mid-cap P/E ratio divided by large-cap P/E ratio), small and mid caps are trading at their steepest discounts versus large caps since the early 2000s.

Discovering Small- and Mid-Cap Stocks

Growth-oriented investors looking to add equity exposure could consider incorporating small and mid caps into their portfolios.

With superior historical returns and relatively attractive valuations, small- and mid-cap stocks present a compelling opportunity for investors capable of tolerating greater volatility.

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