On the yield curve’s bear steepening in a period of cyclically low credit spreads

I was off last week when the Fed raised rates a quarter percentage point. But I promised to comment on the Fed’s action when I returned. I am doing so now.

Before I left, I wrote a piece about two weeks ago on the steepening of the yield curve. And even though this is considered bearish, over the near-term, I think it’s a bullish signal. It’s only when it impacts credit that bear steepening becomes bearish. Some thoughts below

Defining bear steepening

What I said last time was that rising rates are considered bearish irrespective of whether the yield curve is flattening or steepening. As long as short-term interest rates are rising, the curve dynamic gets the moniker ‘bear’ for either bear flattening or bear steepening. But these two situations are telling us very different things.

When short rates are rising more quickly than long rates and the yield curve is flattening, it is a sign that the Fed is tightening enough to alarm markets. Here, over the medium-term, markets expect the Fed to be forced to stop rate hikes or even reverse them. So bear flattening is definitely bearish, and not just because short rates are rising but also because the market is signalling it expects the economy to roll over, forcing the Fed to pause.

On the other hand, bear steepening, what we’re seeing now, is a sign that the Fed has room to run. It is a sign that the economy is doing well enough that markets don’t believe the Fed’s rate hikes will dampen growth in the medium-term, forcing them to stop or reverse course. So over the short-term, this is bullish. It’s only over the medium-term when rate hikes translate into credit distress that the ‘bear’ part of bear steepening rears its head. I expect to see those signs in 2019 but not in 2018.

On the Fed’s reaction function

Goldman is bullish on the US economy, so much so that they are now talking about 5 hikes through the end of 2019. They say:

We continue to expect five more rate hikes through the end of 2019, with risks to the upside. Chairman Powell’s comments and the lessons from past cycles suggest that this risk could take the form of either a faster pace of hiking if inflation surprises to the upside or a longer hiking cycle if growth and the labor market remain stronger than we expect in 2020.

And Jay Powell is sounding very bullish indeed. Here’s Bloomberg today:

There’s a powerful person in Washington besides the president who can barely contain his enthusiasm for the U.S. economy.

It’s the man Donald Trump appointed to head the Federal Reserve and whom he’s attacked for raising interest rates: Jerome Powell.

In what Fed watchers say was unprecedented four public appearances over the past week, Powell repeatedly lauded the economy’s performance, calling it “remarkably positive,” “extraordinary” and “particularly bright.” And he said he expected the good times to continue.

“There’s really no reason to think that this cycle can’t continue for quite some time, effectively indefinitely,” Powell said Wednesday at an event in Washington hosted by The Atlantic magazine and the Aspen Institute.

Translation: Given how well the economy is doing, the Fed has room to keep raising rates for the foreseeable future without it wrecking the economy. And the market seems to agree. That’s why the spread between 2- and 10-year rates has moved to 36 basis points.

I had been expecting the curve to continue to flatten into the end of the year, forcing the Fed’s hand on whether it would allow the curve to invert. But the bear steepening has put this off. And it means that the Fed has room to raise rates even more in 2019.

The Fed’s forward guidance

My mantra for the past year has been “I continue to believe the Fed has been and will be more hawkish than the market expects.” And I believe Goldman’s 5 rate hike scenario also says this. Now if you look at the Fed’s actual forward guidance, the only change is in the long-term neutral rate of interest going up to 3% from 2.9%.

Fed Summary of Economic Projections September 2018.png

Source: Federal Reserve

The Fed is still only guiding to three rate hikes in 2019, meaning that Goldman is effectively predicting the Fed will accelerate its timetable by one rate hike between now and the end of 2019. So instead of 3.4% for the Fed Funds by the end of 2020, Goldman is effectively saying we should expect 3.4% by the end of 2019, a full year earlier. And note, that this would be 40 basis points above the long-term neutral rate.

What will the credit impact be?

What I said two weeks ago is this:

I still see 2019 as the key here. Imagine that inflation worries escalate and the curve steepens more even as the Fed raises rates and the short end goes up. We could see the long end of the curve move into the high 3% range or even toward 4%. Steepening of this magnitude would be a death knell for marginal debtors.

Let’s parse this though. Here are two factors.

First, at last reckoning 40% of the value of U.S. corporate bonds was rated BBB.

Corporate Bonds - BBB.png

Source: Wall Street Journal

The impact of interest rate hikes is greater on these almost-junk issuers than on higher-grade issuers. So, effectively, the entire corporate bond rate structure makes corporate bonds more risky compared to in prior credit cycles.

Mitigating that somewhat is the fact that the average maturity of US investment grade bonds is almost 11 years. That’s the longest since 2000. And it insulates these companies from having to raise as much capital over the coming months as interest rates rise. It’s not good for investors because that duration risk erodes corporate bond value at a faster clip. But it is a mitigating factor regarding susceptibility to balance sheet stress.

So when I say that rising rates will be a death knell for marginal debtors, let’s think of the risk being more toward the end of 2019 than the beginning. And this will be greater in CCC companies than BBB.


The Bloomberg Barclays U.S. Corporate High Yield Bond Index has returned 2.4 percent in 2018, more than just about any other fixed-income market. And the lower the rating, the better the performance: Securities seven to nine steps below investment grade (CCC, or Caa) have gained 5.5 percent, while the most distressed debt has soared about 31 percent.

This is all due to spread compression. Junk bond spreads are at their lowest since 2007. When rates go up, the opposite will be true.

Junk bond spreads.png

For now, times are good. And people are willing to take on more risk as a result. As always, caveat emptor. The dynamics will change in 2019.


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