Significant shifts in the economy are often heralded by changes in the shape of government bond yield curves. The U.S., U.K. and German curves are now all flattening together. Usually, that would be good economic news after a downturn: With growth re-established, markets would be anticipating rate increases. But the current picture isn't so straightforward.
The situation may be closest to normal in core Europe. Germany is booming, inflation pressures are starting to show up, and the European Central Bank is making hawkish noises about interest rates. The end result is a classic bear-flattening move: Two-year Bund yields have risen sharply to 1.44% while 10-year yields have risen more gradually to 3.15%, narrowing the gap between the two. That bear-flattening seems likely to continue if Germany continues to steam ahead and the ECB moves towards a rate increase; the bond market move indicates faith in the recovery.
In the U.K., a similar shift has taken place, but there's a twist. The Bank of England, under pressure due to stubbornly high inflation, is also moving toward a rate increase. But some fear the economy is too fragile to withstand higher interest rates given fiscal tightening and the poor state of the housing market. A rate raise could potentially lead ultimately to lower 10-year gilt yields —a so-called bull-flattening—if the fears of the doves at the BOE come to pass and the recovery is damaged.
The U.S. curve, meanwhile, is flipping between bear-steepening and bull-flattening: With two-year yields effectively nailed down as the Federal Reserve is standing pat, all the action is being driven by 10-year Treasury yields. At the start of the year, with hopes for strong U.S. growth, 10-year yields rose in a bear-steepening move; now the Middle East turmoil, the potential oil shock and downgrades in U.S. growth mean 10-year yields have fallen again. Until two-year yields rise, the bond market isn't signaling confidence in the recovery.
Investors need to know what variety of curve shift is under way. A bear-flattening with good growth implies a classical recovery: Risk assets should fare well. A bull-flattening curve implies renewed worries about growth, with potentially increased economic volatility. The worst of all worlds would be a sharp bear-steepening with a lack of growth. That would imply central banks have lost the plot on inflation but haven't succeeded in stimulating the economy: stagflation.
Write to Richard Barley at firstname.lastname@example.org