While the deflation/inflation debate rages on, the jump in US gov­ern­ment bond yield (and stronger com­modi­ties and weaker US dol­lar) seems to indi­cate that defla­tion­ary pres­sures are moderating.

The chart of the US 10-year Trea­sury Note yield shows a clear uptrend since the end of last year, with the yield also now trad­ing above both the 50– and 200-day mov­ing averages.

Source: StockCharts.com

The graph below shows the rel­a­tively flat yield curve (red line) imme­di­ately prior to the first rate cut in Sep­tem­ber 2007. As indi­cated by the black line, the yield curve has steep­ened dra­mat­i­cally since as mon­e­tary pol­icy kept shorter matu­ri­ties at low lev­els while longer matu­ri­ties have been in a ris­ing trend.

Source: StockCharts.com

A steeper yield curve typ­i­cally her­alds bet­ter tid­ings for eco­nomic growth, although con­cerns about mas­sive issuance also come into play. The graph below shows the close rela­tion­ship between the US GDP-weighted Pur­chas­ing Man­agers Index (PMI) and the US 10-year Trea­sury Note yield.

Source: Plexus Asset Man­age­ment (based on data from I-Net Bridge)

This raises the ques­tion as to what the impact of the yield curve typ­i­cally is on the stock mar­ket. The blue line in the chart below shows the US 10-year Trea­sury Note yield rel­a­tive to the US 2-year Trea­sury Note yield. A ris­ing blue line indi­cates a steep­en­ing yield curve, whereas a down­ward trend shows the oppo­site. A com­par­i­son with the S&P 500 Index high­lights a broadly inverse rela­tion­ship, i.e. stocks fall when the yield curve steep­ens and rise when the curve flattens.

Source: StockCharts.com

A key obser­va­tion, how­ever, is that the stock mar­ket usu­ally bot­toms prior to a peak in the yield curve, i.e. as con­fi­dence regard­ing an eco­nomic recov­ery gains ground and earn­ings prospects improve.

Impor­tantly, the steep­en­ing of the yield curve com­prises two phases: firstly, when both short– and long-term rates fall but short rates fall more than long rates as a result of poor eco­nomic con­di­tions and, sec­ondly, when long rates start dis­count­ing bet­ter eco­nomic prospects but short rates are still kept at low lev­els. The sub­se­quent decline in the yield curve is when both short and long rates increase, but short rates rise faster than long rates. Share prices typ­i­cally rise dur­ing the sec­ond phase of the steep­en­ing of the yield curve and the ensu­ing decline.

The above analy­sis is merely one cog of the wheel, but seems to sup­port the argu­ment that US stocks are in all like­li­hood in a broad bottoming-out phase. As said before, investors will now focus on the second-quarter earn­ings reports as a test of whether stock prices bear resem­blance to fun­da­men­tal real­ity. In the mean­time, a cau­tious approach is war­ranted but that should not pre­clude one from find­ing stocks that look cheap.

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Dr. Prieur du Plessis is an investment professional with 26 years' experience in investment research and portfolio management. More than 1,200 of his articles on investment-related topics have been published in various regular newspaper, journal and Internet columns, including his blog, Investment Postcards from Cape Town. He has also published a book, Financial Basics: Investment. Prieur is Chairman and principal shareholder of South African-based Plexus Asset Management, which he founded in 1995. The group conducts investment management, investment consulting, private equity and real estate activities in South Africa and a number of foreign countries. He also serves as Honorary Consul of Slovenia for South Africa, actively developing economic, cultural and scientific relations between Slovenia and South Africa. Prieur is 54 years old and live with his wife, television producer and presenter Isabel Verwey, and two children in Cape Town, South Africa. His leisure activities include long-distance running, traveling, reading, motor-cycling and scripophily. Read more from the author/contributor here.

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