The yield curve is exhibiting a rare and dangerous trend.
Welcome to the bear steepening!
What are bond investors trying to signal here?
A bear steepening of the yield curve happens when rates move higher but it’s long-dated yields that take the lead, hence shifting the entire curve higher but also steeper.
How to interpret such a move?
Think of 10-year yields like a strip of all future Fed Funds for the next 10 years, discounted to today. This will help you follow the rationale.
Up until recently, markets priced in Fed cuts until a terminal rate of about 3% was reached in a couple of years.
A gentle cutting cycle starting in Spring and lasting for about 18 months until a neutral nominal interest rate of 3% was hit.
But bond investors are starting to change their mind now.
Stronger GDP, a resilient labor market and solid retail sales data have convinced markets that the US can handle higher interest rates for longer.
So the yield curve is bear steepening.
That bear steepening implies that the Fed cutting cycle will now be much shallower with a new equilibrium nominal rate at 4%, and most importantly that a higher terminal rate will NOT negatively impact the US economy down the road.
Or in other words: investors are now expecting that the US economy is structurally strong enough to withstand higher equilibrium rates!
But bear steepening moves also come with counter-effects.
Bear steepening regimes cause long-dated yields to rise, and this has a large and rapid tightening effect on the real economy: 30-year mortgage rates and corporate borrowing rates rise rapidly across the curve, financing becomes even tougher and negative mark-to-market effects (see regional banks) are amplified.
Stock markets are already starting to notice.
This is why in all three recent cases (Sep-Nov 2000, May-Jun 2007 and Sep-Nov 2018) rapid late-cycle bear steepening moves marked the end of the ‘’this time is different’’ experiment and ended up causing severe distress to economies (2001-2008) or markets (Q42018).
Will this time be different?
Is the US economy really able to handle 4.00% nominal interest rates as the new equilibrium level?
Surely, a very very loose fiscal stance is helping.