When the yield curve flattens and eventually inverts, you worry.
But it’s when a recession hits, the Fed cuts rates and the curve steepens that you become s**t scared.
Yield curve dynamics represent a crucial macro variable, as they inform us on today’s borrowing conditions and on the market future expectations for growth and inflation.
An inverted yield curve often leads towards a recession because it chokes real-economy agents off with tight credit conditions (high front-end yields) which are reflected in weak future growth and inflation expectations (lower long-dated yields).
A steep yield curve instead signals accessible borrowing costs (low front-end yields) feeding into expectations for solid growth and inflation down the road (high long-dated yields).
Rapid changes in the shape of the yield curve at different stages of the cycle are a key macro variable to understand and incorporate in your portfolio allocation process.
So, let’s cover the 4 major yield curve shape movements which are so important for macro and market conditions:
1) Bull Flattening = lower front-end yields, flatter curves.
Think of 2016: Fed Funds already basically at 0% and weak global growth. Yields stay put at the front-end and could meaningfully move lower only at the long-end, hence bull-flattening the curve.
2) Bull Steepening = lower front-end yields, steeper curves.
Late 2020, early 2021: the Fed was keeping rates pinned at 0% and stimulating via QE but the economy was flooded with fiscal stimulus and ready for reopening. The friendly borrowing conditions and the massive upcoming growth boost could mostly be reflected through higher long-end yields, while 2-year interest rates were pinned at 0% by the Fed. Bull-steepening of the curve.
3) Bear Flattening = higher front-end yields, flatter curves.
2022 was the bear flattening year: Powell raised rates aggressively to fight inflation, but he ended up choking the economy off. This was reflected in lower future growth and inflation expectations at the long-end of the curve. Front-end rates went higher, but the curve bear-flattened.
4) Bear Steepening = higher front-end yields, steeper curves.
Do you remember 2009? The worst of the GFC was behind us and (monetary-mechanics-illiterate) investors were afraid that QE would lead to runaway inflation and the Fed would be forced to start acting on it. Front-end yields moved a bit higher, but long-end yields took most of the hit as investors (mistakenly) bumped the inflation risk premium up = the curve bear-steepened.
Recently, the curve has shifted from bear flattening as Powell hiked rates aggressively and killed future growth expectations to bull steepening as markets expect the Fed to be forced to cut rates soon as something breaks.