Investors anticipating a faster pace of curve steepening, one that sends short-term rates decisively below those with longer maturities, need to see compelling evidence of a much weaker economy that would force the Fed’s hand. Instead, the current trajectory points to a gradual easing cycle stemming from a slowdown in inflation and moderating growth. The US central bank itself envisions only three-quarters of a point of cuts this year.
“In normal times it’s the short rate that comes down sharply given a recession is coming, and that causes the dis-inverting,” said Tobias Adrian, director of the International Monetary Fund’s monetary and capital markets department. “But now the US is likely to have a soft landing and so basically the curve could just flatten.”
Of course, conditions may shift quickly. Roger Hallam, global head of rates at Vanguard, sees two potential catalysts for a steeper curve. “One is a recession or a financial accident that causes the Fed to ease more quickly and significantly than expected. That’s a bull steepening case in an adverse outcome,” he said, referring to a situation where yields across the curve fall, with short-term yields leading the decline.
A more problematic outcome would be if longer-dated yields push higher, as seen last year when a surging US deficit raised concerns about financing for the US Treasury. “The deficit challenge in the US remains very material,” and one cause of steeper curve would be a “Fed easing before inflation is truly slain,” as the market seeks more of a term premium for holding longer-dated bonds, Hallam said.
Across the entire Treasury market, yields on three-month bills aren’t far from the lower end of the current policy band, 5.25% to 5.5%, so this part of the curve still remains heavily inverted.
Bills sit more than 1 percentage point above a 10-year yield of 4.16%, a negative relationship that has existed for at least 14 months from October 2022. That period does mark the average lead time of inversion before the previous four recessions, according to Campbell Harvey, the Duke University professor who first established the predictive qualities of an inverted curve back in the 1980s as regards economic downturns.
“How this is going to play out is largely to do with the Fed cutting rates,” Harvey said in an interview. “The Fed has to cut fairly substantially to get to the point that we don’t have an inversion.” Campbell doesn’t rule out a far longer period of inversion between bills and longer-dated Treasuries. “The curve could stay inverted for all of 2024.”
Stephen Bartolini, a fixed-income portfolio manager at T. Rowe Price, warns of another scenario for curve watchers. “If we have a re-acceleration in the economy, the long end of the curve could give up a lot,” he said. After the bond market’s late-year rally helped to drive down benchmark borrowing costs, “we’ve had substantial easing of financial conditions.”
Put another way, “there is the happy steepener, which is what everybody wants, which is when you get cuts,” AlphaSimplex’s Kaminski said. “Then there’s the not-so-happy steepener, which would be a situation where long-term yields go higher.”
This article was provided by Bloomberg News.