The latter part of this week was interesting to the extent the resurgence of the inflation narrative seemed to be at least partially responsible for a (probably fleeting) reversal of the previously inexorable flattening of the curve.
2s10s steepened for three straight sessions to close the week, rising from a mere 41bp on Wednesday – the smallest gap in more than 10 years. Still, as noted on Friday afternoon, on the whole there wasn’t anything too dramatic about the week:
The spike in commodities – catalyzed by surging metals prices on the heels of the Russia sanctions and the ongoing rally in crude – stoked inflation concerns and on Friday, 10Y yields surged to their highest levels since 2014, reigniting the debate about what happens when we hit the elusive 3%:
Are we set for a rerun of early February, when inflation jitters and bear steepening accompanied an acute risk-off episode and a spike in cross-asset volatility that left investors with few places to hide? Well, who’s to say in the very near-term, but for their part, Deutsche Bank thinks “the stability of the long end remains unshaken.”
That’s according to the latest from the bank’s Aleksandar Kocic, who notes the following in a note dated Friday:
Fiscal shocks, which started with bear steepening, are gradually migrating to the front end and the curve continues to bear flatten. In this way, the Fed is normalizing the curve and supporting the currency. As a result, supply is (always) finding a sponsor, and the long end of the curve benefits from any riskoff episode or portfolio rebalance. This is stabilizing long rates and, as consensus forms around the idea that a breakout from the range is becoming unlikely, backend volatility is gradually getting extinguished, which is reinforcing its stability further. Rates volatility is departing in all directions, to the short end of the curve and to other markets.
The figures show two snapshots of the curve, current and at the end of October, as well as changes across the vol surface between the two dates. We note the bear flattening of the curve and migration of volatility to short tenors, in particular the outperformance of the upper left corner. The pattern is slightly exaggerated due to FRA-OIS widening.
The late week selloff notwithstanding, there are still a variety of factors supporting the long end – these are familiar to most. There’s the rate diffs argument which, hedging cost considerations aside, support demand. There’s the fact that, as mentioned above and as clearly evidenced during some of the more acute risk-off episodes we’ve seen over the last three or so months, the safe-haven bid shows up when things get particularly dicey for stocks. Etc. Kocic has recently observed that all of this tends to push vol. away from rates and as he notes on Friday, that only “reinforces the appeal” of bonds.
Next, he revisits his previous discussion about the transmission of market dynamics into inflation (more here). Without that transmission mechanism, there’s no motive for the Fed to effectively murder the cycle or otherwise “burst the bubble” by overshooting. Here’s Kocic, from the note cited above:
In the 2004-2007 tightening cycle, consumers’ ability to borrow at low rates and invest in real estate was inflationary. The inversion of the yield curve did not forecast the recession; it was a function of the regulatory environment and global flows. The Fed had to overshoot and effectively burst the bubble, which caused the recession.
For the time being, Kocic says, Fed hikes will support the dollar, effectively helping underwrite and perpetuate the bid for the long end and also curb inflation pressure. For Kocic, curve inversions “will not be the predictors of recession” but rather, “it will be the distance between the short and neutral rates.”
Implicit in all of this, however, is the steady buildup of tail risk. What happens, for instance, when the recession finally does show up and it comes against a backdrop where the U.S. fiscal position has been deteriorating steadily thanks to late-cycle deficit spending? What happens if the regulatory environment continues to trend in the direction of aggressive deregulation? More to the point, who will provide the bid when the Fed is forced to cut rates to combat a downturn in an inflationary environment with a flagging currency? Here’s Kocic one more time:
Long yields would likely fail to rally or could even sell off in an easing cycle. The persistence of Fed hikes and curve flattening could become an incubator for vicious steepeners in the future. It could force one-sided positioning and make potential recessionary Fed intervention only more disruptive.
Kocic thus calls the current situation “incubated steepeners”.
Something tells us this is an underappreciated tail risk, indeed.