The bond market is trying to send investors a message. A lot hinges on how they interpret it.
In recent weeks, the yield on the 10-year Treasury has risen to 4.15%, 0.28 percentage point more than the two-year Treasury yield. That could mean one of two things: better economic growth ahead—or a big problem.
At first glance, the message in the bond moves makes sense. The two-year yield is more sensitive to changes in monetary policy, and the Federal Reserve isn’t expected to be making any major changes in its interest-rate policy. That was confirmed following this past week’s benign consumer inflation print, which did nothing to change the disinflation narrative. The chance of a September interest-rate hike sits at 11%. The 10-year yield, which is more responsive to growth expectations, has been rising as recession concerns have eased.
But there’s a complicating factor: The move might not be driven by expectations for more growth. Earlier this month, the Treasury Department increased the estimated amount of debt it would have to issue during the second half of the year. Since then, investors have been more reluctant to bid for longer-dated notes and bonds at auction, driving prices down and yields higher.
Don’t think the stock market hasn’t noticed. This past Thursday, the
S&P 500 index
looked set for a big gain after July’s consumer-price-index report—until the completion of an auction of 30-year bonds. The auction results were disappointing enough to send yields higher and cause stocks to give back their gains, says Barry Knapp, director of research at Ironsides Macroeconomics. If that continues, it could mean more volatility for stocks and bonds.
Here’s the issue: Bond traders never look at the yields on individual maturities, but at multiple yields across different maturities—collectively known as the yield curve. They place bets on whether the curve will “flatten,” meaning longer-term yields will decline faster than short-term ones, or “steepen,” when long-term rates rise faster than short-term ones. When the steepening or flattening happens with bond prices rising and yields falling, it’s called a bull, and when it happens the opposite way, it’s called a bear.
With the 10-year yield rising and the two-year remaining roughly in place, as it is now, it looks like the Treasury market is in a “bear steepener.” That doesn’t happen very often. The bond market spends about a third of the time in a bear flattener, a third of the time in a bull flattener, and a quarter of the time in a bull steepener, according to Ned Davis Research data. A bear steepener happens less than 10% of time. “A bear steepener is a relatively rare, unstable condition, particularly for late in a tightening cycle,” writes Joseph Kalish, chief global macro strategist at Ned Davis Research.
If the steepening continues, it would be sending a strange message—one that pushes back against the current narrative about muted growth, tame inflation, and a Fed that is finished raising rates. Instead, it would seem to imply growth is accelerating and that a data-dependent Fed will continue tightening.
“The macro message is that the economy is strengthening, and the Fed is expected to hike,” writes Kalish’s colleague Ed Clissold, Ned Davis Research’s chief U.S. strategist. “Put another way, the economy is getting the all-clear message, but the Fed has not overtightened.”
History suggests that’s good for stocks. Clissold notes that the S&P 500 has gained 9.5% a year during bear steepeners, only slightly worse than during bear and bull flatteners. Stocks averaged a 1.9% rise during a bull steepener, when the Fed was cutting rates, likely because of a recession.
Dennis DeBusschere, founder of 22V Research, credits the bear steepening to this year’s rapid disinflation, which suggests better growth prospects ahead. “[The] burden has shifted and evidence that…growth is NOT the driver of the curve is needed before we would take a more defensive stance,” he writes.
Stocks that benefit from a steepening yield curve include
(TGT), he notes.
But what if the bear steepening isn’t driven by growth? Ironsides’ Knapp sees signs that the move in longer-term yields is being driven by the massive supply of bonds coming from the U.S. government. Bear steepeners based on too much supply are very rare, and it won’t be taken well if that’s the case now, he says. He estimates that a continued steepening could cause the stock market to fall 5% to 7%. “[The] bear steepener was a warning shot,” he explains.
The good news: It could finally force the Fed to end this rate-hiking cycle once and for all and provide a buying opportunity.
Write to Ben Levisohn at Ben.Levisohn@barrons.com