Wagers on flattening yield curves have been a winner for most of the past year, with rates on longer-dated securities moving lower relative to shorter-term benchmarks, and in many cases even quite deeply below. Those moves came as traders anticipated and capitalized on the Fed’s sequence of increasingly big rate increases that are aimed at tackling persistently high inflation. The two-year Treasury yield ended this week at around 3.26%, about 28 basis points higher than the 10-year’s at 2.98%.
Whether it remains a winner — becoming even more deeply inverted — depends not just on how many more rate hikes there will be, but also on the economic consequences and the Fed’s tolerance for pain. Powell will open the Wyoming confab with remarks on Friday at 10 a.m. New York time. And speculation is mounting that he’ll strike a hawkish tone that leans against market expectations for rate cuts in 2023 in response to an economic slowdown.
“Powell will want to err on the hawkish side,” stressing that restoring price stability is the top priority, said Tim Magnusson, chief investment officer at Garda Capital Partners, a hedge fund. “The flattener will be in play until the Fed stops tightening,” however, “it’s a harder trade now,” having already moved so much.
Broadly over the past year, episodes of yield-curve flattening have occurred via short-term rates rising more than long-term ones, while steepening has been explained by short-term rates leading the way lower.
The logic is that as Fed rate hikes push policy-sensitive front-end yields higher, the odds of an economic recession in the next 12 to 18 months increase, weighing on longer-dated yields. As the policy rate rises beyond the theoretical neutral level into a zone where it’s restricting economic activity, the flattening trend should gather pace.
The minutes of the Fed’s last policy meeting in July, released this week, showed that some participants expected that once the policy rate “had reached a sufficiently restrictive level,” it would need to stay there “for some time to ensure that inflation was firmly on a path back to 2%.”
This week, however, the curve steepened with long-dated yields leading increases, highlighting the complexity of the trade.
The move — which widened the gap between two- and 10-year rates by about 14 basis points — occurred as hot inflation abroad and comments by Fed officials pushed up market expectations for where the policy rate will peak early next year and further dimmed the outlook for easing later in 2023.
The UK reported on Wednesday that consumer prices increased at a faster-than-expected pace of 10.1% in July, the most since 1982. One-year ahead inflation swaps for both UK and Euro have surged, pricing in worsening cost pressures.
Some of the recent re-steepening of the curve may also have been driven by investors taking profits on flattening trades after the inverted two-to-10-year yield gap reached 58 basis points earlier this month, a level not seen in decades.
On the flip side, curve-flattening has technical support from strong investor interest in buying long-term debt as yields rise, with some citing 3% on the 10-year note — nearly reached on Friday — as a notable opportunity. Flows into US bonds from foreign investors, especially in Japan, also have promoted curve-flattening.
The swaps market is currently priced for the policy rate to reach about 3.7% around March and decline from there. The amount of easing priced in has been pared to about 40 basis points from roughly 80 basis points last month.
“The narrative now is not just how high rates go, it’s how long they stay there,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. “That’s why the market is pushing rate cuts deeper into 2023.”
What to Watch
Aug. 22: Chicago Fed national activity index
Aug. 23: New home sales; Richmond Fed manufacturing index; S&P Global PMIs
Aug. 24: MBA mortgage applications; durable goods orders; pending home sales
Aug. 25: Jobless claims; 2Q GDP revision; Kansas City Fed manufacturing activity
Aug. 26: Personal income and spending (with PCE deflator); University of Michigan sentiment and inflation expectations
Aug. 23: Minneapolis Fed President Neel Kashkari
Aug. 25: Kansas City Fed annual Jackson Hole forum begins
Aug. 26: Fed Chair Jerome Powell at Jackson Hole
Aug. 22: 13- and 26-week bills
Aug. 23: 21-day cash management bill; 2-year notes
Aug. 24: 2-year floating rate note; 5-year notes
Aug. 25: 4- and 8-week bills; 7-year notes