By Paritosh Bansal
(Reuters) – A bond market anomaly that has reliably predicted a U.S. recession in the past could normalize in a highly unusual way this year. It is a concern for the markets.
The market signal, the so-called yield curve, has been upside down since early July 2022, with investors getting less for locking up their money for longer periods than for shorter periods. The US benchmark curve shows that the interest rate on government bonds with a term of two years is approximately 30 basis points higher than that on government bonds with a term of ten years.
In the past, yield curves have typically trended right side up because an economic slowdown prompted the Federal Reserve to cut rates, causing yields on short-term bonds sensitive to the policy rate to fall, a phenomenon called bull steepening.
This time, however, it's starting to look like the curve could normalize as longer-term bond yields rise at a bear steepness, according to interviews with half a dozen investors and other market experts. That's due to pressure on longer-term interest rates from rising US debt, while a surprisingly robust economy and persistent inflation are keeping the Fed from cutting rates.
A bear steepness, which briefly emerged in October, could resume at some point this year, bringing the yield curve back to normal on a rarely trodden path.
“What we saw in the later stages of 2023 was the beginning of that curve normalization,” said Dan Siluk, portfolio manager at Janus Henderson. “We're going to have a continuation of that theme through the 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. Ten-year Treasury yields would need to rise above 5% to normalize the curve, investors estimate, raising corporate and consumer interest costs. Inflation would remain persistent in a bear-stealing scenario.
While a normal yield curve is good for banks, a bear steepness would be difficult to trade and put pressure on stocks, potentially leading to market swings.
Moreover, the normalization of the curve would not mean that the economy could have avoided a recession. Higher long-term interest rates could make an eventual slowdown more likely, and high debt levels would hamper the government's ability to respond.
“It's too early to dismiss this as a false signal,” said Campbell Harvey, a professor at Duke University who first proposed the inverted yield curve as a recession indicator. “It is negative that long-term interest rates are rising.”
Harvey pointed out that the time it takes for a downturn to materialize after an inversion varies, and that in the four most recent inversions the curve turned positive before a recession started.
HIGHER INCHES
To be fair, there may still be a bull steepening. High policy rates could still slow the economy, weaken the labor market and hurt consumers, which could lead the Fed to cut rates. High interest rates can also cause a market disturbance, such as a banking crisis, that forces the Fed to cut rates.
But investors said in the absence of that, conditions were building for a bear steepening. If growth and inflation persist, this could indicate that the long-term equilibrium interest rate for the economy, the so-called neutral interest rate, is higher, putting pressure on interest rates. And the enormous amount of debt that the US government is taking on would ultimately lead to investors charging more for it.
There are some signs of concern among investors in the markets. A New York Fed model that breaks down Treasury yields into its components shows that the premium charged by investors for lending money has risen again over time.
The term premium had turned positive during October's bear steepening, but turned negative later that year when the Fed started steering the market towards lower interest rates. This month it became positive again, 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 a rise in gold prices relative to fair value due to official institutions' demand for safe-haven assets.
That would reduce the number of buyers of government bonds, even as supply increases.
HARD TO PREDICT
What's not clear, however, is when these concerns will take center stage in the markets, which are currently more focused on the Fed rate outlook.
An event like Britain's fall 2022 debt crisis is difficult to predict, although investors said they were watching the spending plans of both U.S. political parties as the November election approaches.
BNY Mellon strategist John Velis said he was concerned about the Treasury Department's August repayment announcement outlining financing needs for the quarter. The one before that, on May 1, is less important because tax revenues would have reduced the need for financing over the summer.
It is more likely that a bear steepening will be a slow process with uncertain timing. However, that makes things more difficult for traders.
Bill Campbell, head of DoubleLine Capital's global sovereign team, said it's expensive to pre-empt trades ahead of a bear steepness, so timing becomes important.
That causes macro hedge funds to move in and out of the trade, Campbell said. Investors are also looking at other ways, such as using smaller trade sizes.
“You just try to find clever ways to attract it,” Campbell said. “In the bear steepness scenario, we think it will become more of a rut higher.”
(Reporting by Paritosh Bansal in New York; Editing by Matthew Lewis)
