US Yield Curve: Steepening Ahead

The US yield curve is on the brink of a significant shift, and understanding this change is crucial for investors looking to navigate the current economic landscape. The Federal Reserve's recent actions and the broader economic indicators suggest that the yield curve is poised to steepen further. Let's dive into the details and explore what this means for your investment strategy.



The Federal Reserve's Role in Steepening the Yield Curve

The Federal Reserve kicked off its monetary easing cycle in September 2024 with a 50-basis-point reduction of the federal funds rate. This move has already had a noticeable impact on Treasury yields, with 10-year yields moving above 2-year yields for the first time since July 2022. This inversion of the yield curve has ended, and the curve is now positively sloped, which is a strong indicator of potential further steepening.

The Fed's messaging suggests that it believes current policy is restrictive, and the rate reduction cycle is just beginning. A significant decline in inflation, from over 9% in mid-2022 to 2.5% in August 2024, has given the Fed additional capacity to ease policy rates. This easing is expected to continue, which should further steepen the yield curve. The Fed's actions are aimed at normalizing the curve to be upward sloping, which is historically associated with stronger growth and better equity performance.

Historical Patterns and Current Indicators

Historical data shows that in the post-Volcker era, when the yield curve previously inverted, it has tended to steepen significantly after moving back into positive territory. This historical precedent suggests that the current yield curve, which has just moved back into positive territory, is likely to steepen further.

Additionally, concerns about the high U.S. fiscal deficit and higher supply of Treasuries could resurface and put upward pressure on long-end yields. With the deficit at high levels for a non-recessionary environment, there’s potential for further steepening, even with resilient economic growth. This is supported by the data showing that UST 30-year yields are 4.90% today, nearing levels not seen since their 2023 spike of 5.15%.

Implications for Different Sectors

The steepening of the yield curve has varied implications for different sectors of the economy. Cyclical sectors are poised to benefit disproportionately from a steepening yield curve in a solid economic environment. Banks in both Europe and the US have historically outperformed the broader market around 80% of the time during periods of yield curve steepening. This is because banks benefit from higher net interest margins when the yield curve steepens, as they can borrow at lower short-term rates and lend at higher long-term rates.

Small-cap stocks, which carry more floating-rate debt than their larger counterparts, tend to thrive in the initial stages of a rate-cutting cycle. Additionally, they could be positively impacted by deregulation and other policy changes that favor smaller businesses. The resilience of the U.S. economy makes a hard landing or recession scenario less likely, but the risk may be underestimated by markets. Weakness in the economy or a sustained rise in unemployment could trigger a larger than expected Fed response, leading to a greater steepening of the curve.

Moreover, concerns about the high U.S. fiscal deficit and higher supply of Treasuries could resurface and put upward pressure on long-end yields, especially as investors demand higher term premiums. With the deficit at high levels for a non-recessionary environment, there’s potential for further steepening, even with resilient economic growth. This could benefit sectors that are sensitive to interest rate changes, such as the financial sector, which includes banks and insurance companies.

Conclusion

The US yield curve is likely to steepen further based on the Federal Reserve's current and anticipated monetary policy actions, historical patterns, and current economic indicators. This steepening has potential benefits for cyclical sectors, small-cap stocks, and the financial sector. However, investors should remain cautious and monitor the broader economic environment to make informed decisions.

As the yield curve steepens, it looks very likely that the ‘free lunch’ in money markets is about to end. Investors may therefore want to adapt their fixed income portfolio accordingly by maintaining some exposure to long-dated high-quality bonds for hedging and diversification purposes, together with lower-quality, shorter-dated bonds to capture some additional yield. Long-duration positions with a purely speculative capital gain objective may be sold after the recent drop in yields. Entry levels into riskier segments such as US high yield have already improved significantly following the events of recent days.

In summary, the steepening of the US yield curve presents both opportunities and challenges for investors. By understanding the underlying factors and their implications, you can position your portfolio to navigate this shifting landscape effectively.