People obsess about outright yield levels, but curve shapes are at least equally important.
The US yield curve has been flattening relentlessly since May this year - chart below shows the yield differential between 5y and 30y US bonds.
This is paramount important.
1/n
The US yield curve has been flattening relentlessly since May this year - chart below shows the yield differential between 5y and 30y US bonds.
This is paramount important.
1/n
Yield differentials between short and long-end of the curve inform you about investors’ expectations on interest rates years down the line.
A steep yield curve means investors demand compensation (term premium) to own long bonds vs rolling ownership of short bonds each time
A steep yield curve means investors demand compensation (term premium) to own long bonds vs rolling ownership of short bonds each time
Premium for what risk?
It can be inflation, (real) duration or credit risk.
In this case, the curve has become flatter so investors demand less premium to own long end bonds - the distribution of probabilities of future interest rates has become easier to predict.
What changed?
It can be inflation, (real) duration or credit risk.
In this case, the curve has become flatter so investors demand less premium to own long end bonds - the distribution of probabilities of future interest rates has become easier to predict.
What changed?
Credit risk (spread between Treasuries and swaps) has barely moved in 5y and 30y.
Inflation expectations have dropped 20 bps, but that’s true for both 5y and 30y breakevens - the curve should not flatten based on this.
We are left with premium to own duration & real rates.
Inflation expectations have dropped 20 bps, but that’s true for both 5y and 30y breakevens - the curve should not flatten based on this.
We are left with premium to own duration & real rates.
Indeed, since May real yields have collapsed in 30y (-30 bps) while they have risen in 5y (+20 bps, admittedly from very low levels).
50 bps compression in real yields differentials between 5y and 30y.
This is also clear looking at 5y forward 5y real yields.
What does it mean?
50 bps compression in real yields differentials between 5y and 30y.
This is also clear looking at 5y forward 5y real yields.
What does it mean?
As the global credit impulse peaked in Q4 last year, soft data + earnings estimates + hard data were all destined to peak somewhere around May/June this year.
The script played out nicely.
A bond investor will demand less premium to own long bonds if the economy is slowing.
The script played out nicely.
A bond investor will demand less premium to own long bonds if the economy is slowing.
A bond investor will demand even less premium if the economy is slowing and authorities embark in policy tightening - as the Fed started announcing in summer.
The distribution of future outcomes becomes less uncertain - tightening at peak credit impulse = lower future growth
The distribution of future outcomes becomes less uncertain - tightening at peak credit impulse = lower future growth
To conclude: watch yield curvatures and not only outright yield levels.
5s30s flattening this quick means the market is not buying the “runaway inflation fueled by Fed monetizing debt and brrr” narrative.
The end.
5s30s flattening this quick means the market is not buying the “runaway inflation fueled by Fed monetizing debt and brrr” narrative.
The end.
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