STEEPENING DOESN'T HAVE TO RHYME WITH DITHERING

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Weekly

March 11, 2024

Not since 1980 has the yield curve been so inverted, and for such a long time

However, investors would be wrong to doubt a return to normality

Despite this setback, the preference for the present will eventually apply

Bill Gross relies on this rationale and on structured products to take advantage of it

CHART OF THE WEEK: "In eight days, the curve will have reversed to set a new longevity record"

BOND MARKET ANALYSIS

Monday 11 March marks the 615th consecutive day on which the yield on 10-year US Treasury bonds has been lower than the yield on 2-year bonds. In the Eurozone, the period of inversion of the yield curve began later, but it is already on its 489th day. In the past, these imposing numbers were surpassed only by the record of 623 days, set between August 1978 and April 1980 (see Chart of the Week). During the first Volcker recession, the Fed cut its main target rate from 20% to 9.5% in just three months. Although this period is often associated with a rigorous application of monetarist principles, the Chairman of the Federal Reserve was pragmatic in his approach. He was prepared to accept deviations from the targets set by the Federal Open Market Committee (FOMC). This controversial decision reflected the difficulty of striking a balance between controlling inflation and preserving economic growth and employment. The Fed's flexibility allowed it to navigate through economic cycles, while maintaining its commitment to strict inflation control.

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From 2023 onwards, we anticipate a gradual return of the yield curves to a more 'normal' state, where the preference for the present is respected and, as a result, yields on long maturities exceed those on short maturities. This process seems to have begun, but it is still in its infancy. Spreads have not yet become positive again; they are simply less negative.

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In March 2023, the curve began to steepen thanks to a sharp fall in the short end (bull steepening). With the Federal Reserve announcing that rate hikes were coming to an end, investors began to anticipate the next phase, when the monetary institution would cut rates. Unfortunately, in May and June, investors had doubts about this scenario and the yield curve inverted again (see Figs. 2 & 3).

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Between 1st July and 31st October, investors once again sought to steepen the yield curve, but in an unusual way, thanks to the rise in long-term rates (bear steepening). Then, doubts set in one more time. As stronger-than-expected growth and inflation figures were published, investors reduced their expectations of rate cuts by central banks. In so doing, they pushed yields on short maturities back up to high levels. As a result, the yield curve has inverted further. The 2/10 curve is currently -42 basis points in the United States and -52 bps in the Eurozone (see Figs. 2 & 3).

Some investment bank strategists are losing patience. Those at JP Morgan are the latest to revise their forecasts for Treasury bonds. They now expect two-year and ten-year yields to end 2024 at 3.80%, compared with 3.25% and 3.65% respectively. This means that they expect the 2/10 curve to be flat at the end of the year, compared with a steepening of +40 basis points in their previous forecasts.

Despite the frustration of this setback, the potential for a steepening of the yield curve remains intact. Bill Gross recently joined investors betting on a steeper curve. In other words, he agrees with our analysis by saying that capitalism, based on finance, depends on a positive yield curve and that, if the curve is inverted, it makes it easy to obtain a high return for a lower risk. This phenomenon is destructive for the economy. For the record, Bill Gross is the co-founder and former chief investment officer of Pacific Investment Management Co, better known as PIMCO, the world's largest bond fund. Once described by the New York Times as the nation's most important bond investor, he retired in 2019 and now manages his own fortune. He also argues that the yield curve will turn positive due to the large supply of Treasuries and a potential slowdown in Fed purchases.

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Bill Gross relies on structured products that appreciate when the inversion of the yield curve is reduced. Specifically, he buys September 2024 contracts linked to the Secured Overnight Financing Rate and sells those for September 2025. Currently, the rate on the shortest contract is around 98 basis points higher than the rate on the longest contract. The investment will pay off as the spread narrows.

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Conclusion:

The yield curve has already begun to steepen, but its trajectory is still in its early stages. The recent pause should not give investors cause for doubt. The preference for the present will continue to gradually reassert itself.

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