The Big Picture
Briefing.com Summary:
*Bull steepener, bull flattener, bear steepener, bear flattener: defined.
*The slope of the yield curve holds various implications for the stock market.
*Equity investors aren't seeing a threat from where long-term rates currently stand.
The Federal Reserve is going to cut the target range for the fed funds rate at the September 16-17 FOMC meeting... or so the market thinks. That thought process is evident in the fed funds futures market, which currently places an 86.9% probability on the likelihood of a 25 basis point cut to 4.00-4.25%, according to the CME FedWatch Tool.
It is also evident in the Treasury market, specifically in the 2-yr note yield, which has dropped 32 basis points in August to 3.62%. That move was catalyzed initially by the July CPI report, which was deemed better than feared, and secondarily by Fed Chair Powell's speech in Jackson Hole, where he acknowledged "the shifting balance of risks may warrant adjusting our policy stance."
What hasn't adjusted as much as the 2-yr note yield is the 10-yr note yield and the 30-yr bond yield. The former has declined 14 basis points in August to 4.22%, while the latter has increased three basis points to 4.91%.
The 2-yr note yield moving down faster than the 10-yr note yield and 30-yr bond yield is known in the Treasury market as a "bull steepener" trade. Today, we will unpack what that means while shedding light on some other esoteric trading terms applicable to yield curve dynamics.
Playing with "House Money"
A steeper yield curve, up to a point, is not a bad thing. Banks enjoy it since they borrow at short-term rates and lend at longer-term rates. Pension funds like higher long-term rates because they reduce the present value of their future liabilities. Fixed-income investors like a steeper yield curve since it allows them to lock in higher rates while taking on duration risk.
A steeper yield curve is often associated with a positive economic outlook because it is driven by expectations of lower interest rates that would be supportive for growth.
The short end of the curve is more reactive to changes in the fed funds rate than the long end, which is influenced more heavily by other forces like inflation and inflation expectations, the budget deficit and what that means for issuance, and the growth outlook.
It certainly hasn't escaped the market's eye that the yield curve is steepening at a time when inflation rates are closer to 3.0% than the Fed's 2.0% target. To be fair, long-term rates, which are more sensitive to inflation, have fallen this year despite all the hubbub about tariffs. The notable exception is the 30-yr bond. It is up 13 basis points this year to 4.91%.
The increase in the 30-yr bond yield has coincided with the rise in yields for longer-dated securities around the globe. That, too, is drawing some attention amid the tariff pressures and increased fiscal stimulus seen the world over.
Global stock markets, though, are at or near multi-year highs, if not all-time highs. That suggests equity investors aren't seeing a fundamental threat—not yet anyway—from where long-term rates stand. That is understandable here in the U.S. and for good reason.
The 10-yr note yield had climbed to 4.80% in mid-January, threatening a run at 5.00%, but it sits at 4.22% today. That is down 35 basis points since the start of the year, which is remarkable given the higher effective tariff rate now in play, the ongoing budget deficit, the weaker dollar, and the sticky inflation.
In a manner of speaking, then, the market has some "house money" to play with before long-term rates get to a point that truly spooks the stock market. It's a pretty comfortable dynamic right now with a normal sloping yield curve and a bull steepener trade that reflects a positive economic outlook more so than an inflation scare or deficit dustup.
A Bearish Development
An inflation scare or a deficit dustup would likely induce a "bear steepener" trade. That is a dynamic where the spread also widens, but because long-term rates rise faster than short-term rates.
That's not a good situation for the housing market, as mortgage rates are tied loosely to the 10-yr note yield. It's not a good condition for loan demand in general, given the higher cost of financing. It can also be a destabilizing situation for the stock market, given the competition posed by higher risk-free rates and the lower present value of future earnings stemming from the higher rates.
In turn, the velocity of a rate move can oftentimes be more unsettling than the level of rates, as it creates added angst around the move and certainly misgivings about the economic and earnings growth outlook.
The Flattener Trade
At this juncture, it may not surprise readers to hear that there is a "flattener" corollary to these steepener trades. They are aptly referred to as "bull flattener" and "bear flattener" trades.
The bull flattener is a product of long-term rates coming down faster than short-term rates, thereby leading to a narrowing of the yield spread. This dynamic is likely to unfold when market participants anticipate lower inflation or an adverse economic environment, like a recession.
If it is the latter, that is a bad setup for stocks (initially) since a fear of a recession or weak economic environment is bad for earnings prospects, but at the same time that would also invite expectations of rate cuts. It can be a particularly good circumstance for stocks if it is tied simply to inflation coming down since that, too, would invite rate cut expectations; meanwhile, lower long-term rates increase the present value of future earnings.
The "bear flattener" trade isn't the stock market's friend. This is a situation where short-term rates rise more than long-term rates, leading to a narrowing in the yield spread. This trade will likely take root if market participants are fearing higher inflation and/or an overheating economy that would lead the Fed to raise rates.
Short-term rates rising faster than long-term rates, and maybe even exceeding long-term rates (i.e., an inverted yield curve), isn't great for bank lending activity. Moreover, when the yield curve inverts, that is when recession alarm bells start ringing. History has shown on more than one occasion, though, that inversions can be false economic alarms; nonetheless, inverted yield curves typically lead to more cautious-minded investment activity.
Briefing.com Analyst Insight
These trades can happen on any given day, yet it is the shape of the yield curve over time that makes them resonate as a mover of capital markets given what they imply about the interest rate and economic outlook, both of which are intricately linked.
To recap:
- Bull steepener = short-term rates move down faster than long-term rates
- Bull flattener = long-term rates move down faster than short-term rates
- Bear steepener = long-term rates rising faster than short-term rates
- Bear flattener = short-term rates rise faster than long-term rates
The bulls are running right now in the stock market, and they are also running in the Treasury market with the bull steepener action. It is a good trend dynamic, but it is one that would turn less friendly if long-term rates start rising appreciably. That, too, would invite a steeper yield curve but with a different connotation (a bear steepener) wrapped up in concerns about inflation and/or the deficit.
That's not where the market's mind is at right now, and hopefully it won't have to go there. If it does, there will be less shine on the stock market outlook.
