Flat Yield Curve Faces a Rocky Road That Offers Little Direction

What a Flattening Yield Curve Signals About the Economy

The U.S. yield curve had its big flattening moment. Now expect some turbulence ahead, with little change in altitude.

At least two quantitative techniques suggest a shift is under way in fixed-income markets. The Treasury yield curve from five to 30 years is entering a period of increased volatility, but less clear directional moves. That means curve bets will have less potential to generate excess return.

The yield spread between five- and 30-year Treasuries tumbled to 76.2 basis points Tuesday, the lowest since November 2007. Reasons abound for the trend: The Federal Reserve is raising short-term interest rates in the face of stubbornly low inflation; asset-liability managers are relentless in their duration buying; Treasury is expected to increase issuance primarily in the short end of the curve; yields are higher in the U.S. than in many other developed markets.

Peter Cecchini, Cantor Fitzgerald’s chief market strategist, discusses what the flattening yield curve means.

(Source: Bloomberg)

So what’s next? A technique known as PCA decomposition reduces the curve to three factors -- level, slope and twist. Feeding those into what’s known as a Hidden Markov model reveals four curve regimes:

  • Low volatility, steep curve
  • Low volatility, flat curve
  • High volatility, flat curve
  • High volatility, steep curve

For most of the past year, the market has been alternating between the two flat-curve regimes. The recent transition to high volatility, if history is any guide, suggests traders should brace for price swings that are three times greater than in the previous regime.

That switch matters to investors because it means the yield curve may move dramatically flatter or steeper on a daily basis, but not over longer stretches. Therefore, returns from those bets will be smaller. Historically, interest-rate levels explain most of the variance in performance, and they become even more important in a high-volatility regime.

Meanwhile, the price-momentum relationship for the yield curve from five to 30 years resembles early July. At the time, the spread hit a new low closing level, but the move wasn’t confirmed by momentum indicators. That sort of divergence can often provide more credible signals than outright oversold or overbought readings.

If the yield spread continues to narrow in the coming days, it would signal exhaustion of the trade and should trigger bets on steepening. That happened on July 6, when the gap widened the most in four months.

Taken together, the models show traders should expect more curve volatility, but a less obvious curve trend. In other words, expect the curve to hover around current levels for the time being with plenty of daily noise -- at least until the regime shifts again.

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