How Bullish is a Bull Flattener?March 27, 2014
Over the last 4.5 months the spread between the 30 year treasury yields and 10 year treasury yields has fallen from 112bps to 85bps, a difference of 27bps, and that spread has been falling fast in recent weeks. This has occurred in the backdrop of 30 year yields falling while 10 year yields have remained basically flat. Under this scenario the narrowing of the spread between 30s and 10s (i.e. a flattening of the yield curve) is referred to as a bull flattener. This namesake, however, can be misleading because in a situation where 30s are falling faster than 10s it is either because very long-term inflation expectations are falling, very long-term growth expectations are falling, or both. That type of situation doesn’t sounds very bullish (!), but let’s see what the charts say.
Given that both 30s and 10s have generally been on a downward trajectory since 2009 and 30s have fallen more than 10s over that period, we have a good sample set of five years by which we can generally assume that any flattenings of the yield curve have been bull flattenings. So how have growth sensitive assets like copper, EM stocks, and the S&P500 responded to flattenings and steepenings since 2009? We observe a fairly tight correlation between the 30-10 spread and both copper and EM stocks (i.e. as the 30-10 spread narrowed copper and EM stocks fell, and vice versa). The same was true for the S&P500 until 2013 when relationship came unglued.
How have inflation sensitive assets like gold responded to flattenings and steepenings since 2009? Basically in the same way the growth assets have responded (i.e. flattening of the yield curve has resulted in a lower gold price).
Finally, how has the ultimate bid-to-quality asset, the USD, responded? Here we notice that the yield curve has maintained a very tight relationship with the USD, but on an inverted basis. When the yield curve flattens the dollar strengthens.
Having established a few macro relationships with the long end of the yield curve, we will simply remind readers that the bull flattening of the yield curve has accelerated in recent weeks and is close to making a downside breakout. If a downside breakout does occur and past relationships continue to hold we should expect lower prices for assets sensitive to inflation and growth expectations and a stronger dollar.