It was the trade that pushed yields on the longest-maturing Treasurys to year-to-date highs last week, while knocking the momentum out of equities and un-inverting the yield curve for all the wrong reasons.
That trade is known as a bear steepener, which continued to play out in the government fixed-income market during Monday’s session. Bear refers to the sentiment toward the underlying government security, which is to sell it, and steepener represents the pattern in which long-term yields rise at a faster pace than their shorter-term counterparts.
Ordinarily, the bear steepener is associated with an outlook for a strong U.S. economy that can support higher rates years into the future. There’s more than one way to read the trade, however, and this time around it’s being seen as a reflection of rising worry about the U.S. fiscal outlook, fueled by the Treasury Department’s increased borrowing needs and a downgrade by Fitch Ratings.
Fitch Ratings cut the government’s top AAA rating last Tuesday, a day after the Treasury revealed plans to borrow just over $1 trillion in the third quarter. A round of approaching government auctions this week will test investors’ appetite for a deluge of Treasury securities, which the U.S. is using to fund its borrowing.
“While the Fitch downgrade didn’t necessarily cause the steepener, some of the issues it brought to light were very important, such as bigger deficits and more issuance, so a lot of the moves were fundamental,” said Scott Buchta, head of fixed-income strategy for Brean Capital in Franklin, Tenn.
Given the increasing supply of Treasurys, plus quantitative tightening outside the U.S., “over the medium term we definitely think the curve gets a lot steeper or less inverted,” Buchta said via phone. “Higher yields could be perceived as negative for investors should they put downward pressure on equities.”
Last week was a case in point, demonstrating how the Treasury curve can steepen for the wrong reasons. The benchmark 10-year yield BX:TMUBMUSD10Y and 30-year bond rate BX:TMUBMUSD30Y respectively jumped by 23.2 basis points and 28.8 basis points over three days to finish Thursday at 4.188% and 4.304% — their highest levels since early November — as traders and investors focused on the U.S.’s deteriorating fiscal outlook and a better-than-expected jump in private-sector employment.
Meanwhile, the widely followed spread between 2- BX:TMUBMUSD02Y and 10-year Treasury yields, traditionally seen as a reliable indicator of approaching recessions, finished last week at minus 73.1 basis points; that compares with more than minus 100 basis points in early July.
While a less-negative spread tends to be associated with reduced risks of an economic downturn, it’s now being seen as mostly fiscal- and supply-driven.
“The supply issue, more than the Fitch downgrade, weighed on the market and caused the bear steepener last week,” said Larry Milstein, senior managing director of government debt trading at R.W. Pressprich & Co. in New York. The market’s sentiment behind the bear steepener right now is a “negative” one considering the possibility that borrowing costs could go even higher, exacerbating the U.S. deficit, as the Fed keeps hiking rates to combat inflation.
“This week’s auctions are going to tell us if we extend that trade further and what kind of demand we should expect to see at these bigger auctions,” Milstein said via phone on Monday. “If they go OK and are digested pretty well by the marketplace, that’s a positive and we may not see an extension of the bear steepener. But even that would not necessary signal an all-clear.”
On the hand, he said, the trade has more room to run “if things are sloppy and tough to digest.”
On Monday, 10- and 30-year yields bounced back from the declines they experienced on Friday, yet finished short of their 2023 highs, as investors sold off long-dated government debt once again. Meanwhile, the 2-year rate fell, leaving its spread versus the 10-year yield at minus 68 basis points. U.S. stocks finished higher, led by a 1.2% rise in Dow industrials.
Monday’s Treasury-market moves, in which the 2-year yield dipped as 10- and 30-year rates went up, amount to what’s known as a “twist bear steepener,” according to Ben Emons, senior portfolio manager and head of fixed income at NewEdge Wealth in New York.
“Bullish trends are in place to be broken and this is happening to long-term rates,” he said. “The reversal of the year of the bond triggered another selloff” on Monday ahead of Thursday’s consumer-price index for July.