By Jamie McGeever
ORLANDO, Florida (Reuters) – The surge in long-dated U.S. bond yields currently underway and driving the so-called ‘bear steepening’ of the yield curve will dramatically reduce the economy’s chances of achieving the fabled ‘soft landing’ and avoiding recession.
High and rising long-term borrowing costs tighten financial conditions by making it more expensive for businesses and consumers to roll over debt or get credit, and more expensive for companies to invest.
A steepening yield curve is when the spread between long- and short-term bond yields widens. Either the long-term yield rises faster than the short-term yield – a bear steepener – or the short-term yield is falling more – a bull steepener.
The curve is aggressively bear steepening now as investors dump long-term bonds. But what makes this situation even harder to navigate is the fact that the curve is still inverted – the two-year yield is still higher than the 10-year yield.
Bear steepenings of the benchmark two-year/10-year U.S. Treasury yield curve, when the curve is inverted, are rare.
Warren Pies, founder of research firm 3Fourteen Research, classes a bear steepening as when the 10-year yield rises 50 basis points or more while the two-year yield stays largely unchanged. He reckons there have been 12 episodes in the past 50 years including the current move, four of them around 1980-81.
Dario Perkins at TS Lombard in London reckons there have been six bear steepenings in periods of broader curve inversion going back to the late 1960s, again including the current one.
The historical sample size is relatively small, and the precedence for what follows is pretty patchy. But the flags raised are more red than green.
“The hope is that it’s something like 1968, a recession scare that didn’t materialize,” says TS Lombard’s Perkins. “But financial conditions are tightening, which isn’t great.”
FORCING THE FED’S HAND?
Credit card and mortgage rates are the highest in decades, and it is hard to believe this will not have a negative impact on the economy. ‘Bond King’ Bill Gross, co-founder of bond giant PIMCO, tweeted this week that a 30-year mortgage rate of 7.7% “shuts down” the housing market.
From an economic perspective, there is a certain irony at play – long-dated yields are soaring partly because incoming data suggests the economy is far more resilient than most observers, including Federal Reserve policymakers, had expected.
Other factors are pushing up long-end yields and steepening the curve – a deteriorating U.S. fiscal picture, rising debt issuance, hedge fund activity in the futures market, and investors demanding a higher ‘term premium’ or compensation for the risk of holding long-term debt.
But the recession that many people have spent the last year or more calling for simply hasn’t materialized. Not yet, anyway. Pies at 3Fourteen Research, notes, “continuously doubling down on a recession that never comes is a surefire way to lose credibility.”
Yet tightening financial conditions will make that more likely.
According to Goldman Sachs, U.S. financial conditions are the tightest in almost a year, tightening 114 basis points since mid-July. Higher long rates account for 44 bps of that, the biggest single factor.
The 10-year yield this week hit 4.88%, the highest since just before the Great Financial Crisis, driving a substantial ‘steepening’ of the two-year/10-year curve.
The curve inversion has rapidly shrunk to 30 basis points – before the Fed rate decision and upwardly-revised policy outlook on September 20 the inversion was 80 bps, and in July it was 110 bps, the deepest inversion in more than four decades.
In some ways, a positive-sloping yield curve is the natural order of things. Long-dated yields should be higher than short-dated ones as they generally reflect a higher growth, inflation, policy and term premium outlook.
But the curve may not nomralize this time around.
Tom Graff, head of investments at financial planners Facet Wealth, notes that the lows in the 2-10 curve always coincide with peaks in the fed funds policy rate. If this cycle follows that pattern, the bear steepening will soon lose steam as an economic slowdown brings down long yields.
“This (current steepening) is the market saying it can handle much higher rates than it had previously assumed. But there’s a natural limit. It’s unprecedented for the yield curve to uninvert without the Fed cutting rates,” he said.
Graff reckons the bear steepening is almost over and the curve will struggle to get past -20 bps.
(The opinions expressed here are those of the author, a columnist for Reuters.)
(By Jamie McGeever; Editing by Andrew Heavens)
