A light in the bond shake-out gloom: steeper yield curves

A picture illustration of crumpled kuna, Dollar and euro banknotes

By Jamie McGeever

LONDON (Reuters) – Fears that the era of super-charged central bank stimulus could soon end have sent tremors through global bond and stock markets, but the spike higher in borrowing costs may yet offer the financial system a crumb of comfort: steeper yield curves.

The gap between two-year and 10-year government bond yields has widened recently, with Japan’s curve more than doubling to its steepest in seven months. The U.S. curve is at its steepest since June and the euro zone’s its steepest since May.

A yield curve steepens when the gap between long- and short-dated bond yields widens, and is usually symptomatic of a broadly healthy economy and financial system.

Typically, investors demand higher yields for lending to governments for longer periods to compensate for the greater inflation and credit risks.

Banks make money by borrowing short-term funds cheaply and lending at higher rates over the longer term, while steeper curves help insurance firms and pension funds meet their long-term commitments.

But yield curves, especially between two- and 10-year government bonds, have until recently been the flattest in many years — a quarter of a century, in the case of Japan.

This is partly because central banks’ huge bond-buying stimulus has crushed longer-term yields. It also reflects investors’ views that inflation and economic growth — and therefore interest rates — will remain low for years to come.

But with signs a gradual shift in thinking among policymakers may be underway, markets are reacting.

“It has dawned on pretty much everyone that a flattening yield curve has drawbacks, especially for banks, insurance firms and pension firms. That may not sit easily with the central banks though,” said Peter Schaffrik, chief European macro strategist at RBC Capital Markets.

“It’s way too early to say there’s a trend underway here, and I don’t expect it to last. But typically, steeper curves reflect expectations of a better future.”


There have been two periods in recent years where yield curves steepened quickly: the weeks and months following the so-called ‘taper tantrum’ in May 2013, and the German Bund ‘flash crash’ in April last year.

In May 2013 then-Federal Reserve chairman Ben Bernanke hinted that the Fed would soon begin scaling back its QE bond-buying, and in April 2015 German bond prices buckled under the weight of historically extreme market positioning.

Both led to a steep rise in yields and curves. Both were relatively short-lived and the multi-year flattening trend resumed.

G3 bond yield curves: http://tmsnrt.rs/2cpmcUp

Stocks and bond markets are at, or close to, their highest levels ever. Central banks’ appetite for further inflating them with even more stimulus is waning, especially given the diminishing economic returns from doing so.

Sources told Reuters on Wednesday that the BOJ will consider making negative interest rates the centerpiece of future monetary easing, underscoring growing concerns over the limits to the BOJ’s stimulus efforts, as more than three years of aggressive bond buying is draining market liquidity.

It would also be a shift away from the BOJ’s unique monetary experiment that attempted to crush yields across the curve and try to convince the public that its massive money printing would boost economic activity and prices.

On top of this, markets were disappointed by the European Central Bank’s inaction at its last policy meeting and several Federal Reserve officials have recently sounded more inclined to raise U.S. interest rates by the end of the year.

The spike in yields has rattled all markets. Wall Street’s fall last week was its biggest since February, while the ‘fear index’ gauge of U.S. stock market volatility <.VIX> almost doubled and oil prices have slumped 8 percent.

“Bonds are so dependent on central banks that any slight perception of change in policy has substantial effects,” said Steve Barrow, head of G10 strategy at Standard Bank in London.

“Steeper yield curves would help alleviate the pressure on banks, but central bank policy isn’t to help out banks, certainly not in terms of their profitability.”

Not all curve steepening would be welcome, however. Runaway inflation and fears that central banks were powerless to stop it would be worrisome.

But with U.S. and euro zone five-year inflation expectations near their lowest on record, and Japan back in deflation, there seems little chance that will happen anytime soon.

(Reporting by Jamie McGeever; Graphic by Nigel Stephenson; Editing by Catherine Evans)