Macro: Sandcastle economics
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Summer will bring deeper yield curve inversions on both sides of the Atlantic
Althea Spinozzi
Head of Fixed Income Strategy
Summary: From today, the US yield curve is the most inverted since 1981 as front-term yields outpace the rise of long-term yields. The bond market is pushing interest rate cuts further down the line while pricing higher chances for a rate hike this month. Yield curves on both sides of the Atlantic are poised to further bear-flatten this summer as front-term yields need to catch up with their swaps. Although that might provide better entry points, the front part of the yield curve already provides enticing returns for buy-to-hold-investors seeking to create a bond ladder. Yet, investors should be wary about adding duration risk to their portfolio as long-term yields remain in an uptrend amid a resilient economy. Opportunities for a barbell might open at the end of summer.
With the Independence Day holiday at the doors, markets will have reduced flows today and tomorrow. However, starting from Wednesday, liquidity will return to the US with the release of the FOMC minutes. Jobs data on Friday are critical ahead of the July Federal Reserve meeting, although we don't expect a slightly weaker reading to stop Powell from hiking again. Yet, a surprise on either side might move bond futures, which are now taking another rate hike for granted but struggling to price a second one.
We expect the yield curve to continue to bear-flatten throughout summer, led by the rise of front-term yields.
Today, the spread between 10-year and 2-year US Treasuries broke below March lows, falling to -110 basis points in the morning for the first time since 1981.
The US yield curve will continue to invert for a straightforward reason: short-term yields will likely surge to catch up with the DOT plot and as markets push further down the line expectations of a rate cut.
Long-term yields still have room to move slowly upward if the economy remains resilient; otherwise, they will drop if a recession is forecasted. Either way, the yield curve is meant to flatten, and it could continue to invert to test the 1981 low of -154bps.
Ten-year yields are likely to rise to test 4% as inflation and activity data remain resilient. Last week’s core PCE index came at 4.9%, well above the Federal Reserve target, while the Consumer confidence number for June came at 109.7 versus a neutral 100. Tha puts upwards pressure for yields across the yield curve, particularly on short-term yields.
The yield curve flattening trend is poised to accelerate in Europe
The inversion trend might accelerate in the old continent during summer as swap spreads in Germany and in the UK remain well above the US one, indicating that two year Gilts and Schatz are trading rich on the curve, and in relationship to their swaps.
What does that mean?
- It means that bonds with short-term maturities might cheapen further. Therefore, a better entry point might present itself in the next few weeks. However, we believe that already now the front part of the yield curve offers enticing returns for buy-to-hold-investors, which are seeking to create a bond ladder.
- Investors should be wary about adding onto duration risk. Long-term bonds’ market value suffers from larger moves as interest rates change. Thus, as long-term yields remain in an uptrend due to a resilient economy, it might not be prudent to add on duration risk yet.
- It might soon shape the perfect environment for a barbell, which will allow investors to take advantage of high interest rates in the short part of the yield curve, while benefitting from long-term bonds’ convexity.
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