Article / 06 December 2017 at 11:00 GMT

Weekly Bond Update: Don’t be scared of a flat yield curve

Manager, Global Sales Trading / Saxo Bank
Denmark

  • Flattening of the curve will continue regardless of Trump’s tax bill
  • Inflation is the only thing that can fix the yield curve
  • Short-term maturities may provide yield while waiting for better opportunities

volatility

Longer maturities are typically more sensitive to volatility. TF Montage: Shuttterstock


By Althea Spinozzi


Here we are, finally in December, the most eagerly awaited month of the year. Children are getting busy writing their wish lists to Santa and investors are doing the same, however the addressee is not the fat man with a long white beard dressed in red, but a less romantically dressed up Janet Yellen.

In a nostalgic attempt to be remembered before Jerome Powell becomes the chairman of the Federal Reserve, I am sure Yellen is reading all investors’ wish list and wondering whether that so rumored interest rate hike it the wisest thing to do just before leaving the office and heading to the Christmas holidays lull.

 An interest rate hike is widely anticipated and the only way Yellen can surprise the market is to dovishly leave rates as they are and hand Powell the task instead. Many would regard this as a remote possibility. However, in the past few weeks this has been alarmingly discussed by financial news all over the world which seems to be much scarier than Stranger Things’s Demogorgon and it is called “flat yield curve”.

The spread between the 10-year and 2-year treasury yields has been scarily falling since 2014 and now we are at levels previously found in 2007. The scary thing about this is that in the past, a flattening of the yield curve has anticipated a recession and a bear market.

What is happening is that investors have been starved for yield for too long and now if one wants to place money to safety, Treasuries are the only ones to provide a little bit of yield, with the 10-yr Treasuries yields at 2.34%, the 10-yr bunds at 0.29% and 10-yr Japanese government bonds at 0.048%. In this environment, the majority of foreigner investors are buying longer and longer treasuries. At the same time, whenever the Fed hikes interest rates it bring up yields in the shorter part of the curve provoking a compression of the spread between longer and shorter yields.

Another big reason for a flattening US yield curve are the sluggish core CPI numbers which suggest it is not the perfect time to hike interest rates. But even though the Fed will raise interest rates the market is so hungry for yield that little is going to change.

Just to give you an example of investors' big appetite are for yield, this year frontier markets have issued many bonds, which have been oversubscribed. Recently the new USD bond issuance of Indonesia was covered 2.5x, Argentina 4x, Mongolia more than 6.5x etc. This means that investors will buy whatever offers a better yield, and as they know that the Fed may hike rates several times in 2018 they will stay away from short term securities that they know that will pay a higher yield shortly in the future and they will buy the longer part of the curve.

Everything points to the fact that bond prices are deemed to stay higher for longer, but does a flat curve really suggest there is going to be a recession?

At this point an answer to this question becomes more and more difficult. As a matter of fact, with the passing of the tax bill last week everything may be changing again. The reality is that a looser fiscal policy requires a tighter monetary policy meaning that at this point the Fed will probably see itself forced to hike interest rates more than forecast as the US economy grows faster next year. This would increase Treasury bond yields. However, as the economy grows, inflation would rise in the next few years impacting mainly maturities in the short end of the curve making the yield curve even flatter. The real risk here is if the economy were to get hotter than at present, then the fall might be even harder than anticipated.
 

The real problem is that the yield curve is getting flatter and flatter everywhere:
10y-2y in Germany US and Japan


Source: Bloomberg

 

It is true that the Treasury yield curve partly dictates the movement of global yields, however, at the moment sluggish core inflation is the common denominator that is causing the flattening of global yield curves and until we see a significant uptick in this data it will be hard to see the shape of the yield curve changing.

It feels almost like we are trapped in the “upside-down” (again, if you didn’t watch Stranger Things you don’t know what you are missing) except we are living in a bull market, which we are not able to catch by the horns.

Although it is true that as the yield curve continues to flatten, short term maturities will become cheaper in the foreseeable future, investors shouldn’t discard them completely. Remember: buying a bond means locking in a specific yield, thus if one believes that in 2018 there is going to be a correction in the equity market, it's better to gain a little bit more yield in shorter maturities so that once the bond is repaid, it will be possible to invest in better opportunities. Also, longer maturities are typically more sensitive to volatility and we all now live in an uncertain world, where North Korea launches missiles every other week and the president of the United States is outrageously unpredictable.


— Edited by Clare MacCarthy

Althea Spinozzi is a sales trader at Saxo Bank

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