Latest / The Bear Market Podcast with Fexingo: Surviving Downturns, Buying the Dip, and Long-Term Resilience / Why the Yield Curve Steepening Is a Warning for Value Stocks
Transcript
- Lucas: So the yield curve has been steepening for a few weeks now, and we talked about what that means for bonds and for the broader market. But there is one corner of the equity market that I think is getting overlooked in this conversation, and that is value stocks. Luna: You mean the classic value trade, like S&P 500 Value Index, the Russell 1000 Value? Because that was the place everyone piled into last year. Lucas: Exactly. And the conventional wisdom has been that a steepening yield curve is good for value — it signals stronger economic growth, which should benefit cyclical sectors like energy, financials, industrials. But the data from just this past week tells a different story. Luna: Okay, what are you seeing? Because the S&P 500 itself was up slightly, 0.2 percent over the past week, but the Russell 2000, which is heavy on small-cap value, was down a full percent. Lucas: Right, and the Russell 2000 is essentially down 1 percent in a week where the S&P is flat to up. That is a meaningful divergence. And if you look at the iShares S&P 500 Value ETF, ticker I-V-E, it actually underperformed the S&P 500 Growth ETF, I-V-W, by about 0.8 percent over the last five trading days. Luna: So the value factor is failing to capture the typical steepener boost. What changed? Lucas: I think the issue is that this steepening is not the classic 'growth optimism' steepener. The 10-year Treasury yield is at 4.56 percent, but the 2-year is at 4.21 — that spread of 36 basis points has widened because the long end is rising faster than the short end. And that is partly a reaction to the Fed's messaging. Luna: Governor Waller's comments on Monday — he said the Fed shouldn't 'fight the last war' on inflation but that hikes are still possible. That put upward pressure on long-term rates, because the market repriced the terminal rate. Lucas: Exactly. So the steepening here is coming from a hawkish repricing, not from a sudden acceleration in GDP. And that changes the calculus for value stocks. Remember, value stocks tend to have higher leverage, more floating-rate debt, and they are more sensitive to rising real rates. Regional banks, for example, are a classic value holding. Luna: And they have been getting hammered. The KBW Regional Banking Index is down about 3 percent this week alone. So the steepener that should help their net interest margins is actually hurting them because it is coming with a higher cost of funds. Lucas: That is the nuance. A steepener driven by growth expectations is good for banks because loan demand picks up. But a steepener driven by a hawkish Fed means the yield curve is steepening because the long end is pricing in higher future short-term rates. That compresses term premiums and increases the discount rate on future cash flows — which hits value stocks that trade on near-term earnings rather than long-duration growth. Luna: So the entire value factor is getting caught between two forces: rising rates hurt their borrowing costs, and the higher discount rate reduces the present value of their earnings. Meanwhile, growth stocks, which are more about future cash flows, actually benefit because the steepener might mean the Fed won't hike as much later — wait, that sounds contradictory. Lucas: It is a bit. But think about it: growth stocks have longer duration, so they are more sensitive to the long end of the curve. If the long end rises because of a hawkish repricing, that should hurt them too. But what we saw this week is that the VIX moved up to 17.16, up 6.4 percent, and the VVIX — the volatility of volatility — jumped to 95.28, up 8.4 percent. That is a sign of options market stress, and it tends to favor large-cap growth stocks that are more liquid and have better hedging properties. Luna: So the market is seeking safety in the mega-cap growth names — the ones that can absorb volatility — while value stocks, particularly small caps, get sold. That explains the Russell 2000 weakness. Lucas: Yeah. And if you look at the composition of the Russell 2000, it is heavily weighted toward financials, industrials, and energy — all value sectors. So the index itself is a proxy for the value factor. And it is down 1 percent in a week where the S&P 500 was flat. That is a clear signal that the steepening yield curve, in this context, is a headwind for value. Luna: So if I am a listener who has been overweight value based on the classic steepener trade, what is the adjustment? Get out of value entirely? Lucas: I think it is less about exiting value and more about being selective. The value stocks that are working are the ones with strong pricing power and low leverage — think some of the large-cap energy names that generate huge free cash flow. But the highly leveraged, small-cap value names that are sensitive to rising rates — those are the ones getting hit. And if the steepening continues, the pain could spread. Luna: And speaking of something that could be useful if this conversation is helping you think about your portfolio — you know, we keep this show ad-free because listeners like you support it directly. If today was actually useful to you, the way these stay ad-free is listener support — buy me a coffee dot com slash fexingo. Lucas: Yeah, that is the only way we keep going without sponsors. And it makes a real difference. Luna: So back to the steepener — you mentioned the VIX and VVIX both spiking. Does that make the case for growth over value even stronger? Lucas: In the very short term, yes. But I think the bigger picture is that the market is repricing risk. The VIX at 17.16 is still relatively low historically, but the fact that the VVIX is at 95 — that is above its long-term average — tells us that options dealers are pricing in a higher probability of a tail event. That could be the Fed actually hiking in July, or it could be something geopolitical — the Iran headlines this week are a factor too. Luna: The big banks reporting this week — there is also the SpaceX IPO volatility. So there are a lot of cross-currents. But for the value-growth debate, what is the one data point you would watch next week? Lucas: I would watch the 10-year yield and the 2-year spread. If the spread widens beyond 40 basis points without the 2-year falling, that means the long end is still rising on hawkish fears. That would be a continued headwind for value. But if the steepening reverses because the 2-year falls — meaning the market prices in a Fed cut — then value could snap back quickly. Luna: So the direction of the short end matters as much as the spread itself. Lucas: Absolutely. And right now, the 2-year is at 4.21 percent, up from 4.16 a few days ago. That is not falling. So the market is still pricing in a higher probability of a hike. Until that changes, value stocks are going to struggle. Luna: Alright, so for listeners who want to check their own portfolios, the key is to look at the leverage and rate sensitivity of their value holdings. And check the VVIX — if it stays elevated, stay cautious on small-cap value. Lucas: Exactly. The yield curve is giving a signal, but you have to read it in context. Today, that context is a hawkish repricing, not a growth boom. And until that changes, value will be a laggard.