•  A flattening/ inverted yield curve doesn't spell imminent danger for stocks

It's non-farm payrolls day and the focus shifts back to the US economic recovery

Recently there has been some positive signals from the US labour market:

1. a pick up in the employment sub-indices of both ISM manufacturing and services surveys

2. the 4-week moving average of initial jobless claims dropped below the crucial 400,000 mark last week.

Eventually this should start to feed into non-farm payrolls data - the measure looked at by the Fed when it tries to gauge the strength of the economy.

Although Fed governor Bernanke remains concerned about the economic recovery and thinks the economy still needs Fed stimulus, the Treasury curve is telling a different story and the market is acting as if the period of low interest rates will be over before the Fed starts to signal a more hawkish bias.

The 10-year yield minus the 2-year yield has been flattening in the past couple of months (see chart below) and since the start of February it has been on a downtrend. This means that 2-year yields have started to rise at a faster rate than 10-year yields, which suggests that the market is getting ready for rate hikes from the Fed in the coming months.

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What does this mean for stocks?

The chart below shows 10-2 year yields (white line) and the S&P 500. As you can see, the S&P tends to move higher when the yield curve is steepening (interest rates are falling) and falls when the rate curve inverts (rates are rising), but with a long lag. So stocks can still appreciate even if short-term rates are moving higher.

In 2003 when the Fed started to tighten interest rates the stock market rally continued until mid-2007.

Since rates are at such low levels it could take a while for the Fed to normalise interest rates, especially since the economic recovery remains fragile, so the stock market rally may not be over yet.

S&P 500 (yellow line) 10-year-2-year yield curve

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Conclusion:

Higher interest rates might not spell immediate disaster for equities, in fact, as rates rise pushing bond prices down equities may become a more attractive asset to hold and we could see even more inflows into stocks.

Today's non-farm payrolls data is crucial to the near-term direction for rates, and could precipitate more flattening in the yield curve and boost stocks as we end the week.

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Kathleen Brooks| Research Director UK EMEA | FOREX.com

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