By Paritosh Bansal
(Reuters) – A bond market anomaly that has reliably predicted a U.S. recession in the past may normalize this year in a highly unusual manner. It’s a worry for markets.
The market signal, called a yield curve, has been upside down since early July 2022, with investors getting less to lock up their money for longer periods than they are for shorter durations. The benchmark U.S. curve shows yields on 2-year Treasuries are about 30 basis points higher than 10-year bonds.
In the past, yield curves typically become right-side up as an economic slowdown leads the Federal Reserve to cut interest rates, bringing down yields on near-term bonds that are sensitive to policy rates, a phenomenon called bull steepening.
This time around, though, it is starting to look like the curve may normalize because longer-term bond yields would rise in a bear steepening, interviews with half a dozen investors and other market experts show. That is due to pressure on longer-term rates from increasing U.S. debt, while a surprisingly robust economy and sticky inflation keep the Fed from cutting rates.
A bear steepening, which briefly reared its head in October, could resume at some point this year, leading the yield curve back to normal through a rarely trodden path.
“What we saw in the later stages of 2023 was the beginning of that curve normalization,” said Dan Siluk, a portfolio manager at Janus Henderson. “We’ll get a continuation of that theme through the back end of 2024.”
Both the shape of the curve and the reasons for its steepening have important implications for the real economy and Wall Street. The yield on 10-year Treasury bonds would have to rise above 5% for the curve to normalize, the investors estimated, which raises interest costs of businesses and consumers. Inflation would remain sticky in a bear-steepening scenario.
While a normal yield curve is good for banks, a bear steepening would be hard to trade and pressure stocks, leading possibly to market swings.
Moreover, the normalization of the curve would not mean the economy had dodged a recession. Higher long-term rates could make an eventual slowdown more likely, and a high debt load would hamper the government’s ability to respond.
“It’s too early to dismiss this as a false signal,” said Campbell Harvey, a Duke University professor who first proposed the inverted yield curve as a recession indicator. “It is negative that long-term rates go up.”
Harvey pointed out that the time it takes for a downturn to manifest after inversion varies, and that in the four most recent inversions the curve turned positive before a recession started.
INCHING HIGHER
To be sure, a bull steepening could also still happen. High policy rates could still slow down the economy, weaken the labor market and hurt consumers, leading the Fed to cut rates. High interest rates could also cause a market ruction, like a banking crisis, that forces the Fed to lower rates.
But investors said absent that, conditions were building up for a bear steepening. If growth and inflation persist, it would suggest the long-run equilibrium interest rate for the economy, called the neutral rate, is higher, putting pressure on yields. And the immense amount of debt the U.S. government is taking on would eventually lead investors to charge more for it.
There are some signs of investor worries in markets. A New York Fed model that breaks down Treasury yields into its components shows the premium investors charge for lending money over time has been inching up once again.
The term premium had turned positive during the October bear steepening, but fell into negative territory later that year as the Fed pivoted to guiding the market on lower rates. It turned positive again this month, most recently on April 24.
Another indicator of the broader concern: the price of gold and bitcoin.
Pramol Dhawan, head of Pimco’s emerging markets portfolio management, attributed an increase in the price of gold over its fair value due to demand from official institutions for safe-haven assets.
That would reduce buyers of Treasuries even as supply increases.
HARD TO PREDICT
What is not clear, though, is when these concerns will become front and center for markets, which are more focused on the Fed rate outlook at the moment.
An event like the UK’s debt crisis of autumn 2022 is hard to predict, although investors said they were watching for spending plans of both U.S. political parties as the November election approaches.
BNY Mellon strategist John Velis said they were concerned about the Treasury Department’s August refunding announcement, in which it lays out the borrowing needs for the quarter. The one before that on May 1 is of less concern as tax receipts would have lessened the need for funding through the summer.
More likely, a bear steepening would be a slow process with uncertain timing. That, however, makes it harder for traders.
Bill Campbell, who heads DoubleLine Capital’s global sovereign team, said it is costly to put trades ahead of a bear steepening, so timing becomes important.
That is leading macro hedge funds to go in and out of the trade, Campbell said. Investors are also looking at other ways, such as using smaller trade sizes.
“You’re just trying to find clever ways to put it on,” Campbell said. “In the bear steepening scenario, we think it’s going to be more of a grind higher.”
(Reporting by Paritosh Bansal in New York; Editing by Matthew Lewis)
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