Get Ready For Bull Steepening


Like all markets, the treasury market is highly cyclical. The yield curve undulates from steep to flat as the underlying economic environment waxes and wanes. Determining where we are in the economic cycle is difficult, but the yield curve can help investors make tactical adjustments to their overall portfolio allocations and make an educated guess as to where we are in the economic cycle. Currently, the yield curve is very flat, meaning short-term treasury rates are comparable or even higher than longer-term treasury rates. A flat/inverted yield curve is a typical indication that we are in the latter part of the economic cycle. More importantly, a flat/inverted yield curve does not usually persist for long.

Below is a framework for fixed-income investing based on the yield curve. But before I explain the chart below, a few definitions may help:

Bear Flattening – Short-term yields move higher and faster than long-term yields as the Federal Reserve hikes

Bull Flattening – Long-term yields move lower and faster than short-term yields as the market prices in slower growth and inflation

Bull Steepening – Short-term yields move lower and faster than long-term yields as the Federal Reserve cuts rates to stimulate growth during an economic slowdown

Bear Steepening – Longer-term rates move higher and faster than short-term rates as the market prices in faster growth and higher inflation 

Currently, I believe we are on the precipice of a bull steepening episode as the Federal Reserve reacts to deteriorating economic fundamentals. The Federal Reserve has already cut the benchmark Fed Funds rate 50 basis-points in 2019. Jay Powell has referenced this as a “mid-cycle” adjustment. However, the fixed income market is pricing in an additional two rate cuts by the end of the year. As such, I view the most recent cuts as the beginning of a cycle rather than a simple “adjustment.” Recent macroeconomic data is confirming this thesis. Manufacturing is likely already in a Recession as Manufacturing PMI surveys are all sub-50 – the Maginot-Line between expansion and contraction. Last week’s Service PMI gauge, although above 50, has weakened substantially over the last year, and consumer confidence and small business optimism are all deteriorating. I expect consumption in the U.S. to continue to weaken in the near-term – how much it weakens will determine the depth of the ensuing recession, which at this point, I expect to be shallow. Nevertheless, the Fed will react by continuing to cut short-term rates, perhaps accelerating the rate of cuts in 2020. As a result, I expect the yield curve to steepen. Recall, we had a bear flattening episode from late 2015 to late 2018 as the Federal Reserve methodically hiked. They stopped hiking earlier this year, and a bull flattening episode ensued as the treasury market rapidly priced-in slowing growth. The ten-year and thirty-year yields are currently challenging their all-time lows. Bull Steepening would be the next logical yield curve paradigm.

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