2s10s curves in both the US and the UK inverted on Wednesday, following more worrying data that suggested the global economy is teetering precariously on the edge of a downturn.
On Tuesday, we spent quite a bit of time talking about the read-through of renewed bull flattening stateside for Fed policy and the extent to which the bond market clearly believes Jerome Powell is behind the curve (figuratively and literally in this case).
“Importantly, the 4Q18 into 1H19’s bull-steepening trend is now being powerfully reversed into a rage bull-flattening”, Nomura’s Charlie McElligott wrote, adding that “the earlier steepening was representative of the market pricing-in accelerated Fed easing [while] now, the long-end is rallying in manic-fashion because of the market’s capitulation into a hard growth deceleration/recessionary stance”.
The panic grab for duration in the US is down to the Fed being seen as unable or unwilling (and at this point it doesn’t really matter which) to rescue the world from a downturn and disinflation. As ever, the bond market seems unable to appreciate its own role in dictating this outcome – that is, it is market pricing that has cornered the Fed and made it impossible for Powell to clear the ever higher bar for a “dovish surprise”.
With “recession signal flashes red” (or some derivation of that headline) is destined to be plastered all over the front pages of every financial news outlet on the planet Wednesday, it’s worth asking what comes next for G4 curves.
Goldman takes up the debate in a new note timestamped just prior to Wednesday morning’s inversions in the US and the UK.
“The front end of most yield curves is likely to remain inverted in the near horizon [but] for curves in the US and Canada anchored beyond 2-year maturities, room to cut rates should translate into yield curve (bull) steepening in the event that those central banks ease policy more substantially”, the bank writes.
One key factor at play has obviously been the term premium and Goldman notes that “the amount of term premium compression required to offset the steepening effect of rate cuts (based on historical sensitivities) in the US is large, comparable to the impact of past combined Fed QE programs”.
The implication is that renewed flattening stateside is the product of the Powell Fed’s characterization of the July cut as a “mid-cycle adjustment”, which simultaneously argues against the onset of an all-out, aggressive easing cycle and suggests to pessimists that the central bank may not do what’s necessary to avert a downturn. That’s a recipe for flattening. Throw in some term premia spillover from overseas and it’s little wonder the US curve looks like it does.
But do note in the figures that Goldman is talking about the lower bound or, put differently, the projected “scope” for bull steepening depends on the Fed’s willingness to cut rates aggressively. Alternatively, the term premium cold recover on better data and a brighter outlook for the global economy.
“We do not view the flattening as the start of a trend—in two of three scenarios for the economy, either where there is broad improvement in the economy or a broad deterioration, we expect US yield curves beyond 2-year maturities to re-steepen”, Goldman goes on to say. Again, the idea is that if things deteriorate markedly, the scope for Fed cuts means the curve should re-steepen and if things get better, the term premium will reprice higher, leading to bear steepening.
That leaves a third scenario, though. “We believe the scenario where US yield curves continue to flatten is one where the US economy remains stable or strengthens, even as other large economies continue to deteriorate”, Goldman says, summing up. If that happens, term premia spillovers will continue to weigh on long-end yields while the Fed sits on its hands, constrained in its ability to cut by the still buoyant domestic economy.
Of course, only one of the three scenarios posited above can be fairly described as “good”. It hardly makes sense to root for a severe contraction stateside just so the curve can bull steepen and, indeed, a veritable parade of analysts has argued that it’s the post-inversion steepening you should fear if you’re long any kind of risk.
The scenario that finds the rest of the world continuing to decelerate while the US holds up seems wholly untenable to the extent it encourages more dollar strength, thereby watering down the tariffs and prompting Trump to lean even harder on the Fed and/or intervene in the FX market.
And, really, the benign scenario that sees growth outcomes improve, leading to bear steepening across various locales is only a good thing to the extent it doesn’t get out of control. Just about the last thing a world gorged on duration needs is a disorderly bear steepening episode.