The great yield curve steepening of 2018 barely lasted a day.
After the spread between two- and 10-year Treasury yields suffered its biggest daily widening since 2016 on Jan. 9, it’s gone on a flattening binge. Meanwhile, the curve from five to 30 years touched a 10-year low of 47.2 basis points Tuesday, breaking the mark of 50 basis points that BMO Capital Markets strategists see as a “battleground” on the way to their call for an inverted curve in 2018.
The notion of a bond bear market faded last week almost as quickly as it started, as the benchmark 10-year yield failed to reach its peak since the start of 2017, 2.63%. Also last week, signs of inflation drove two-year yields above 2% for the first time since September 2008, as traders bet the Federal Reserve would have scope to raise rates at policymakers’ projected pace.
Source of Solace
The two-year yield “offers solace for our call that 2018 will be the year the curve flattens to inversion,” BMO’s Ian Lyngen and Aaron Kohli wrote in a report Tuesday. The Fed will continue “with its tightening campaign as long as there isn’t a material breakdown in the real data, regardless of whether or not we ever see the return of term premium.”
The shape of the curve has implications beyond the fixed-income universe. Inversion has tended to be a reliable indicator of impending recessions over the past several decades. When the spread between short- and long-term debt shrinks, it tends to hurt bank earnings and the real economy.
Last week’s ups and downs back up the flattening call, BMO said. Signs of economic strength – including inflation, usually the bane of long-end investors – are now disproportionately negative for shorter-dated securities because they boost expectations for more Fed tightening. Indeed, the 10-year yield rose less than a basis point on Jan. 12, about half the increase on the two-year maturity, after consumer-price figures showed the underlying pace of inflation was accelerating.
The eurodollars market, which is even more sensitive to Fed policy expectations, also shows how traders are concentrating on the front-end.
Demand is climbing for put options on June 2018 eurodollar futures that stand to profit if the market bakes in two quarter-point hikes by midyear. As it stands, overnight index swaps are pricing in 85% odds of an increase in March, and about 1.5 moves through the Fed’s June meeting.
A net 11% of investors in a Bank of America ( BAC ) global fund manager survey expect the U.S. curve to flatten this year, the most since 2015, according to a report dated Tuesday. Traders and strategists cited that bias as a reason why yields surged last week. However, speculators reduced their positions across the curve in the week ended Jan. 9, suggesting a shakeout to a more balanced market.
And on the idea of balance, core CPI rising about 0.3% month-over-month in December hits “the sweet spot” for continued curve flattening, Lyngen and Kohli wrote.
It “justifies continued Fed tightening but does little to convince investors that broader price pressures are truly materializing,” they wrote. “We’ll keep our bias to a flattening and look to set longs at important technical levels.”