Last year, the yield curve went mainstream as an economic indicator, asinversions of the curve sent chills down investors’ spines. That’s because inversions — times when long-term interest rates are lower than shorter ones — have often heralded recessions. Since then, we have indeed fallen into a recession, but one driven by the pandemic, an unforeseen factor. Now the yield curve is showing what else it can do. Currently, bear steepening has taken hold, driven by a tidal wave of monetary support. Here’s a look at what that means, and at the other varieties of yield curve convolution.
First of all, for debt-market newbies, remember that bond prices and yields move in opposite directions. The amount of money a bondholder is due to receive is predetermined, so if one pays less to acquire a security, then the expected return — or yield — goes up. That means that when there’s a bullish move in bonds (that is, people are buying them), yields go down. Conversely, when there’s a bearish shift, yields rise. On top of that, each of these can take place while the curve is either steepening (the premium for longer debt is growing) or flattening (the premium is shrinking).
Here’s a look at four flavors of curve change that can take place:
Recent example: TheU.S. Treasury curve since the first quarter of 2020
What happens: This type of shift could be when the U.S. Federal Reserve already has rates close to zero and pushes them a few notches lower while alsoflooding the system with liquidity (as it did during the height of pandemic risks) – and signals that it plans to keep short-term rates anchored for years to buoy growth and gin up inflation. Hopes for anotherdose of fiscal stimulus to help U.S. output also sent long-term yields higher in September and early October — before President Donald Trump called off talks on a Congressional package — since a strongly reviving economy is more likely to produce inflation down the road.
An example: U.S. Treasury curve from mid-2007 into 2008
What happens: When the market goes into a bull steepening, bonds rally, dragging down yields. Steepening occurs because shorter-dated securities gain the most, pushing their yields down by more than those at the long end. That widens the spread between the two. This type of shift could occur when theFed’s slashing its short-term benchmark interest rates, as it did after the 2008 financial crisis — or even sooner, when traders anticipate the Fed’s moves.
An example: U.S. Treasury curve from fourth quarter 2018 through August 2019.
What happens: Bonds rally for all maturities, with prices rising and yields falling. That explains the “bull” part of the trade. The flattening occurs because longer-dated securities gain the most, pushing their yields lower by more than those at the short end. That compresses the spread between the two, making the curve flatter. This kind of move could happen, for example, when the Fed is holding rates steady but other forces – such a geopolitical frictions – are weighing on growth prospects, or tepid inflation readings encourage buying of longer-term Treasuries (inflation eats away at the fixed payments bonds pay).
Recent example: U.S. Treasury curve in late 2017.
What happens: Bonds sell off, regardless of maturity, with prices falling and yields rising. That explains the “bear” part of the trade. The flattening occurs when shorter-dated securities see their prices weaken the most, increasing their yields at a faster pace than those at the long end. That compresses the spread between the two, flattening the curve overall. Moves like this might take place as the Fed tightens policy while inflation remains in check.
The Reference Shelf
- AQuickTake on the broader implications of a flattening yield curve.
- A Bloomberg Newsarticle on the Fed fueling curve steepening.
- AQuickTake on how Fed could step in tocontrol the yield curve.
- Frequently asked questions on the yield curve from theFederal Reserve Bank of New York.
- Fed Reserve Bank of San Francisco onwhat makes the yield curve move.
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