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Higher interest rates and a steeper yield curve are the first items on all insurance company CEOs' Christmas lists. It's no surprise, then, that insurance stocks surged on May 22 when the yield curve on U.S. Treasury bonds began to steepen. Compound interest on fixed income holdings is a huge determinant of an insurance company's ability to meet its long term obligations to policy holders, so investors in Canadian insurance stocks should pay close attention to U.S. inflation expectations in the months ahead. They should be a major driver of stock performance.
This chart shows the extraordinary relationship between the U.S. yield curve and the performance of Manulife Financial Corp. stock. (Steepness refers to the difference in yield between ten year and two year U.S. Treasuries. A steeper yield curve indicates higher inflation, and interest rate expectations.) The relationship with the Canadian yield curve is also tight, but not quite as much.
I expected a connection between MFC and the U.S. yield curve, but I'm still stunned at how high the correlation is at 0.86 (weekly data from January 2010, r-squared is 0.74). The stock's correlation with the domestic equity benchmark, S&P/TSX Composite Index, is far lower at 0.67. It's hard to imagine another factor being remotely as powerful in determining Manulife's performance.
The implications for investors are clear: shareholders in Manulife (and, to a lesser extent, Sun Life, whose numbers also tested well in this scenario) cannot consider their evaluations complete without assessing the U.S. yield curve and inflation expectations. If, as recent signs indicate, inflation pressure and interest rates are beginning to tick higher south of the border, the prospects for the domestic insurance sector are bright.
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Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.
Scott Barlow