Bond Anomaly That Twisted Yields From US to Germany Is No More
(Bloomberg) -- A quirk in global bond markets that upended traditional relationships between short- and long-term debt in recent years is rapidly fading, with broad implications for economies and investments in more than $40 trillion of government securities.
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After persisting for as long as two years in the US, the so-called inversion in yield curves — an unusual situation where rates on short-term debt exceed those of their longer-term counterparts — is unwinding in many parts of the world.
The normalizing, or steepening, trend first surfaced in July in UK gilts, followed by US Treasuries a month later. Now it’s happening in German and Canadian bond markets as well.
The shift is taking place as central banks start to lower benchmark interest rates after years of keeping them elevated in an effort to tame pandemic-era inflation. With price gains now appearing to be coming under control, policymakers can ease up and turn their attention to ensuring economies don’t stall or slide into recession.
As traders price in this new reality and bet on further rate cuts, that’s triggered a steep drop in short-term market yields. Given the sensitivity of short-dated debt to changes in monetary policy, investors are piling into bets that these securities will benefit more than long-term bonds, sending their yields lower and steepening the yield curve.
“The curve steepening is a global phenomenon that could be even more pronounced in the US,” said Alberto Gallo, the chief investment officer and co-founder of Andromeda Capital Management.
Inverted curves and steepening trends may sound like wonky bond-market events, but the movement underway is worth watching because twists and turns in yields have a long history of signaling investors’ expectations for economic growth. In the US in particular, an inverted curve has a track record of foreshadowing a recession down the road, and some traders see the return to normal as a reflection of the view that a recession — or at least a stark worsening in the economy — is now imminent, forcing a series of deep Fed cuts.
Others, including JPMorgan Chase & Co.’s Bruce Kasman, note that a steeper yield curve, if partly driven by a rise longer-term yields, suggests a “greater confidence in the Fed engineering a sustained expansion.”
For its part, the US economy has so far avoided recession, although the labor market has slowed. That’s opened up a debate over whether a downturn can be avoided in favor of a “soft landing” with the help of Fed cuts; the jury is still out on that.
Meanwhile in Europe, the curve movement stems from slowing inflation and the debate over whether the period of high interest rates has damaged global economies. While the Bank of England and European Central Bank kicked off their rate-cut cycles before the Fed, US policymakers began with a bigger-than-normal half-point cut last week, signaling concern over slowing growth.
“German curves are seeing a strong correlation with US curves where the only trade is steepeners,” said Pooja Kumra, head of European rates strategy at Toronto-Dominion Bank. “So we doubt the steepening move will see any pause in the near term.”
UK and euro-area rate setters are only mandated to keep price growth in check, but the latest manufacturing numbers are hard to ignore, especially in the euro region which showed the recovery has run out of steam. US economic figures released Monday showed business activity expanded at a slightly slower pace in early September, while expectations deteriorated.
The Fed’s willingness to begin the rate-cutting cycle with a half-point move has encouraged investors at asset managers from BlackRock Inc. to Pacific Investment Management Co. to remain positioned for further yield curve steepening. Strategists at Bank of America, BMO Capital Markets and Morgan Stanley are among an array of Wall Street dealer firms expecting similar moves.
Traders are betting on the Fed to keep up a brisk pace of interest-rate reductions, pricing in about three quarter-point cuts across the final two decisions this year, according to swaps to policy-meeting dates. That translates into a wager on at least on more half-point reduction this year — or an inter-meeting cut — even as Fed Chair Jerome Powell said last week that people should not assume now that 50 basis points is the new pace for Fed cutting.
Traders are more undecided when it comes to the ECB and BOE, betting on between one and two such decreases. However, they have raised the chance of a quarter-point rate cut from the ECB in October to around 50% from about 25% last week.
On Monday, comments from a handful of Fed officials left open the door to additional large rate cuts in the US, noting that current rates still weigh heavily on the economy. For some investors, the central bank’s willingness to move forcefully is a positive.
“The Fed is being very aggressive in normalizing policy away from restrictive policy,” said Gargi Chaudhuri, chief investment and portfolio strategist for the Americas at BlackRock, who has been favoring five- to seven-year US Treasury securities. “So bonds can have a really good role to play in a portfolio,” but it matters where you source your bonds, she added.
--With assistance from Edward Bolingbroke and Rachel Evans.
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