Bear steepening, do we need to be worried?

You may have noticed that bond markets are dominating the headlines now and ‘bear steepening’ is doing the rounds. This happens when long term yields rise at a faster pace than short term yields. The US yield curve (10-year Treasury yield – 2-year Treasury yield) has indeed experienced a period of bear steepening. Since July 2nd, the US yield curve has risen by 60 basis points and since April, the US 10-year Treasury yield is up some 120 basis points to 4.52%, which is the highest level since 2007. Although yields are backing away a touch today the trend is clear, US yields are rising at a fast rate, even though the Federal Reserve paused its rate hiking cycle earlier this month. 

The trend higher in rates is not just a US phenomenon, there have been significant bond yield rises for the UK and Germany too, although not to the same extent as US bond yields, and German 10-year yields are at their highest level since 2011. 

Why are long term yields moving higher? 

There are two main reasons why longer-dated yields are rising: 

·      The soft-landing theory: in their summary of economic projections from their September meeting, the Fed now expects US GDP to rise by 2.1% in 2023 and 1.5% in 2024. The long run projection is for growth to average around 1.8% per annum. The US economy is expected to eke outgrowth even though the central FOMC projection for interest rates is more than 5% for next year, and only falling below 4% in 2025. That means that the Fed currently thinks that interest rates will stay elevated relative to recent history for another year or more. Added to this, one Fed member saw the Fed Funds rate rising above 6% later this year. 

·      The term premium: In bond investing, you typically apply a term premium when you hold longer term debt. This is designed to compensate you for taking a chance on a government/ company etc and helping to fund them for the long term. However, in this case, the term premium is rising because investors are demanding more compensation because they think that inflation is here to stay. 

Higher growth and higher inflation have led to this rapid re-pricing at the long end of the US yield curve as the bond market prices in the ‘higher for longer narrative’. 

Does bear steepening matter? 

With a recession in the US failing to materialise, the market now believes that the US economy can handle higher interest rates for a longer period. However, this assumption could be unwise. Bear steepening is relatively rare, and it can be dangerous for the following reasons: 

·      It causes corporate borrowing costs to rise rapidly, and financing becomes a lot tougher. This could cause a rise in loan defaults, or companies choosing not to borrow, leading to weaker growth, and eventually triggering a recession. 

·      Many companies and institutions use long dated bond yields for their business models to function. For example, pension funds and banks etc. This is a big problem for fragile banks, who lend at shorter durations and borrow at long durations. If their interest costs rise at the same time as rates of interest on shorter term lending is falling, then this could cause a cash crunch for some of the weaker or mid-tier banks in the US. This could be exacerbated by the fact that some mid-tier banks are still feeling the effects of the fallout from SVB’s collapse.  This would be a different version of a banking crisis compared to what we witnessed with SVB, but it is still negative for the economy. Likewise, pensions fund themselves with long dated debt to ensure they can pay people in the short term. If that gets too expensive, then some pension funds could be on the line. While there is no sign that any pension fund or bank is currently under stress, if we see another 3-month period with bond yields rising rapidly then we believe that this could change. 

·      Throughout the current monetary policy tightening cycle, there has been a prevailing narrative that this time it is different, and the US and global economy can cope with rising rates. This is very rarely the case. Rapid bear steepening of the yield curve is usually the end of the ‘this time it’s different’ narrative. 

·      High levels of inflation also make bear steepening more dangerous. The Fed is predicting core PCE inflation, its preferred inflation gauge, to remain above its 2% target rate until 2025. Thus, if the financial system starts to show that it is under stress because of rapidly rising bond yields, it could be hard for the Fed and other central banks to cut interest rates to protect the economy from a downturn.  

Overall, investors should not be complacent about bear steepening, as it is unlikely that the global economy can handle higher interest rates for longer. Eventually the market will push long term bond yields so high that something will break. 

However, we believe that there could be a silver lining. While some analysts lament the decline of forward guidance from the Fed and other central banks, who are instead choosing to watch economic data releases closely, we think that forward guidance could be one way for the Fed to reduce the pressure on long-dated yields without having to cut interest rates until the rate of inflation is back at an acceptable level. If the Fed sounds concerned about the rapid rise in yields or starts to worry about the outlook for the economy, then we could see a reversal of the current trend, with long term bond yields falling sharply.