Nasdaq 100 May Outperform the Dow Jones as Treasury Yield Curve Flattens: Q3 Top Trading Opportunities

Nasdaq 100 / Dow Jones Spread– Third Quarter Fundamental Forecast

• The Nasdaq 100 index is heading towards all-time highs at the start of Q3
• A flattening Treasury yield curve makes the tech-heavy index more appealing
• The Dow Jones may be more vulnerable to a rapid rise in near-term rates

See the favorite trades from each DailyFX Analyst for the third quarter. Download our new 3Q top trading opportunities guide from the DailyFX Free Trading Guides!

The Nasdaq 100 index is heading towards all-time highs at the start of Q3, driven by earnings optimism as economic growth rebounds sharply from the depths of the Covid-19 pandemic. The Federal Reserve revised up this year’s US GDP growth rate forecast to 7.0% at the June meeting, underscoring strong momentum while raising concerns about inflation. The June FOMC meeting may serve as an inflection point for the central bank’s monetary policy stance, with a majority of Fed officials hinting at 2 rate hikes by the end of 2023, according to the dot plot. A debate about scaling back monthly asset purchases has also started among key members.

These developments led the US Treasury yield curve to flatten as investors attempted to price in earlier Fed rate hikes and a gradual tapering path. The 10-2 year Treasury yield spread plunged to 118 bps following the June meeting, marking a drastic decline from the recent peak of 156 bps seen at the end of March (chart below). Looking into the last rate-hike cycle, a rapid fall in the 10-2 year yield spread was followed by the Fed’s signal of tapering QE in 2013. This is because front-dated yields tend to rise faster than longer-dated rates during a tapering cycle.

A hawkish shift in the Fed’s monetary policy stance may mark another period of outperformance in the Nasdaq 100 index versus the Dow Jones Industrial Average. This is because a flattening Treasury yield curve makes the tech-heavy index more appealing when the front-end borrowing costs rise faster than the longer-end rates. Large-cap technology firms, such as Amazon, Tesla and Netflix, are particularly sensitive to longer-dated borrowing costs, as their valuations are tilted to long-term growth prospects. Smaller technology start-ups are also less sensitive to short-term borrowing costs as venture capital invested in them is usually locked in for 5-10 years or even longer.

Vulnerability of Value Stocks

For the Dow Jones Industrial Average however, value stocks such as McDonald’s, 3M and Coca-Cola may be more vulnerable to a rapid rise in near-term rates. This is because higher short-end borrowing costs make these dividend-paying stocks less attractive to investors than during an ultra-low interest rate era.

The Nasdaq 100/Dow Jones ratio shows a negative correlation with the US 10-2 year yield spread over the past few months, highlighting the possibility of trading of Nasdaq 100 versus Dow Jones spread as we move closer to a rate-hike cycle. On the other hand however, if the inflationary pressures become sticky and persisting, longer-dated yields may start to catch up with front-end rates, resulting in a steepening yield curve. Under this scenario, traders may consider doing the reverse – that is, looking for the Dow Jones to outperform against the Nasdaq 100.

Nasdaq 100/Dow Jones Ratio vs. US 10-2 Yr Yield Spread

Chart by Margaret Yang, Created with TradingView

See the favorite trades from each DailyFX Analyst for the third quarter. Download our new 3Q top trading opportunities guide from the DailyFX Free Trading Guides!

— Written by Margaret Yang, Strategist for DailyFX.com

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