{"id":57734,"date":"2016-11-07T01:00:00","date_gmt":"2016-11-07T00:00:00","guid":{"rendered":"http:\/\/beta.next-finance.net\/opinion\/curve-steepening-already-been-there\/"},"modified":"2019-12-31T01:13:51","modified_gmt":"2019-12-31T00:13:51","slug":"curve-steepening-already-been-there","status":"publish","type":"post","link":"http:\/\/beta.next-finance.net\/en\/opinion\/curve-steepening-already-been-there\/","title":{"rendered":"Curve Steepening \u2013 Already Been There?"},"content":{"rendered":"

Most developed market yield curves have suffered bear steepening over the past few weeks,
\ndespite quantitative easing (QE). This has been largely due to a less dovish US Federal Reserve
\n(Fed), a change in the Bank of Japan\u2019s policy, the risk of tapering by the European Central Bank
\n(ECB), and the return of inflation (albeit still mild). While we may not retrace previous sell-offs, it
\ncould be worth moving from a long duration bias to a more neutral stance \u2013 looking for return
\ndrivers from credit spreads and steeper curves rather than ultra-long duration.<\/strong> <\/em> <\/p>\n

Recent studies have shown that performance of risk assets has been primarily driven by central
\nbanks\u2019 actions. This has led to strong correlations of performance and pushed investors searching for
\nyield into less traditional sectors such as equities, through dividend strategies for example.
\nMeanwhile, in 2016, duration has been the driver of portfolio growth. So as the \u2018doves cry\u2019, the
\ncurves may steepen and duration risk must be controlled. <\/p>\n

It all started in early September with the traditionally dovish Fed board member Rosengren calling
\nfor a rate hike in the US sooner rather than later. Then the Bank of Japan announced moving to YCC
\nmode (Yield Curve Control), thus implying a change in how they look to let the Japanese government
\nbond (JGB) yield curve steepen, locking the 10-year JGB close to 0%. Meanwhile, the ECB\u2019s potential
\ntaper talks made the headlines as the threat of deflation seems to be fading away, and that the ECB
\ncould be running short of paper to buy before March 2017.<\/p>\n

Markets are watching the next trail of events, notwithstanding the US elections and the December
\nFed and ECB meetings; this could help keep a lid on 10-year yields, but recent economic and inflation
\nfigures may give room for a further steepening of the curves.<\/p>\n

Steeper yield curves? Where to from here?<\/strong><\/p>\n

Last week\u2019s moves in the German 10-year yield are quite rare since the beginning of ECB QE in 2015.
\nMoves of +0.08% or more in a day happened only 12 times since 21 January 2015. Are we in a \u2018taper
\ntantrum\u2019 like in May 2015? It may be too early to tell. Nevertheless, we have seen such moves in the
\npast, which were followed by periods of bull flattening (see Figure 1). On the US side, the move is
\nmore gradual. We are back to levels last seen a year ago. We don\u2019t believe the Fed will announce a change on 2 November, and therefore focus on the December meeting instead. Would a hike mean
\na remake of early 2016? If so the increase in bond yields could soon run out of steam.<\/p>\n

Figure 1: Steeper bellies \u2013 Intermediate (2-10 year) and long end (10-30 year) spread evolutions<\/strong>
\n\"figure_1_-_steeper_bellies_-_intermediate_2-10_year_and_long_end_10-30_year_spread_evolutions.jpg\"<\/a><\/p>\n

Break-evens Calling for US TIPS <\/strong><\/p>\n

Inflation is indeed coming back, not roaring for sure, but it has pushed higher as 2015\u2019s oil price
\ndeclines are disappearing from the year-on-year figures. This drive in 10-year yields going up across
\nthe board is fuelled by the removal of deflation fears. With core CPI in the US at 2.2% and 0.8% in
\nthe euro area, real 10-year yields are still negative. After two years of downside inflation surprises,
\nthe deflation threat seems to be easing, pushing break-evens higher. US 10-year break-evens trade
\naround 1.73% (at the time of writing) while euro equivalents are at 1.07%. Such developments are
\nfavourable for US Treasury Inflation Protected Securities (TIPS). Figure 3 shows the past three-year
\nchange in break-even inflation, highlighting the recent trend higher across the board. <\/p>\n

Figure 2: Change in break-even inflation \u2013 Appetite is picking up<\/strong>
\n\"figure_2_-_change_in_break-even_inflation_-_appetite_is_picking_up.jpg\"<\/p>\n

Move to Cyclicals: Good for Spreads – A Look at
\nthe Belly of the Curve<\/strong><\/p>\n

Spreads have continued to tighten in sterling, US dollar and euro corporate indices despite the
\nrecent increase in treasury yields.
\nManagement of interest rate risk in such a context warrants a more pointed duration exposure.
\nIndeed, the Barclays US Corporate 3-10 Year Index currently has a duration of circa 5.3 vs. 8.4 in an
\nall maturity index like the iBoxx US$ Liquid Corporate Index. In the past 10 years the duration of the
\nBarclays All Maturity IG Corporate Index has been extended by 1.5, from 6 to 7.5. The case for
\ncontrolling duration thus becomes natural. Maturity-based indices offer this opportunity to investors
\nto more precisely adjust their portfolio. In Figure 4 we look at the evolution of yield and spreads in
\nthe intermediate part of the curve recently. <\/p>\n

Figure 3: Yields backing up, spreads tightening \u2013 OAS in bps (LHS) and Yield to Worst in % (RHS)<\/strong>
\n\"figure_3_-_yields_backing_up_spreads_tightening_-_oas_in_bps_lhs_and_yield_to_worst_in_rhs_.jpg\"
\n