10Y bonds fed volatility

Breathe In, Breathe Out

"Waiting to inhale."

It was just Wednesday afternoon when we noted the following:

It’s starting to seem like stocks are worried more about a recession than they are runaway inflation – curve is starting to flatten pretty aggressively.

The is something that Bloomberg’s Ye Xie observed as well, noting that “in early February, the stock correction was accompanied by a steepening yield curve, as the surprisingly strong wage growth caused a simultaneous selloff in Treasuries and equities [but] now, stocks are falling as the yield curve flattens.”

This week’s action is set against a backdrop of lackluster retail sales (which triggered some downward revisions to folks’ GDP forecasts) and a CPI report that printed inline, perhaps vindicating those who think the inflation narrative is overblown.


Fleeting episodes of bear steepening notwithstanding, the overall trend has been a steady grind lower to what many assume is a date with inversion, perhaps catalyzed by a Fed that accidentally hikes the economy into recession.

Well happily, the best analyst on Wall Street is out on Thursday with a brand new note discussing exactly these points.

We are of course talking about the incomparable Aleksandar Kocic from Deutsche Bank who calls this “just another realization of the ‘breather’ mode.”

“It started with bear steepening (BeS) from mid-Jan to 8-Feb, followed by bear flattening (BeF) after that,” Kocic writes, adding that “the reaction of vol reflects this mode of the curve: a bid for long tenors as the market inhales followed by partial retraction, its mirror image.”


Kocic goes on to note what we said above – namely that over the long-term, it’s a steady grind tighter or, more to the point, a net flattening:

This “breather” mode is nothing new; it is a continuation of a persistent pattern post-2013. The mode consists of two parts: the market inhales during short episodes of volatile bear steepening (BeS) followed by extended exhale periods of bear flattening (BeF) grind.


This leads logically to Kocic’s previous discussions re: the “playground” which, you’ll recall, has been shrinking (see here and here). Despite fiscal stimulus (i.e. deficit spending) and myriad other factors that one might think would bear steepen the curve, the long rate is having trouble rising sustainably. Of course the more expansionary the fiscal impulse (i.e. the more convincing is the case that the economic baton can be passed from monetary policy to fiscal policy), the more inclined the Fed is to hike, pushing the short end higher. At a certain point, the “playground” disappears completely.


Kocic goes on to say that although “the long rate sold off in the first two months of this year, it really did not free any space for the curve to reprice significantly as the short term Fed expectations adjusted keeping the gap relatively stable.” In fact, Deutsche observes that after the risk-off episode abated, the proverbial playground actually shrunk some more (see Figure 4).

The takeaway from all of this comes when Kocic notes that we seem to have reached the logical end game here. Here’s a regression of the swaps curve and the playground:


“The important point to notice is that the regression has an intercept: closing of the Fed gap corresponds to 2s/10s at about 29bp,” Kocic writes, before concluding that because the “current 2s/10s is already at these levels [and] with standard deviation of the regression at about 7bp, further flattening below 20bp [is] increasingly unlikely.”

Bottom line: we’re near the limit. If the Fed does indeed try to cram in another hike beyond what’s priced in (as many folks seem to believe they will), they risk inverting the curve and derailing the economy.



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