- The steep inversion of the Treasury yield curve violently reversed last week.
- Such extreme reversals have preceded regime shifts in financial markets.
- The two most recent examples, 2008 and 2020, have very different lessons for investors, however.
You could say that yield curves make their own history, but they don’t make it as they please. The past week’s change in the slope of the Treasury yield curve was its most rapid in decades, as the market reacted to the unfolding bank crisis reminiscent of the 2008 collapse of Lehman Brothers and other financial firms. The slope of sovereign bonds’ yield curves, as well as their volatility, influences everything from consumer credit to bank funding to business investment and, for that reason, is closely watched by investors.
The two most recent examples of such swift steepening are the 2008 global financial crisis and the COVID-19 market crisis of early 2020. Investors may wish to contemplate whether last week’s episode is the culmination of a new regime of market volatility (as in 2020) or whether it’s just getting started (as in 2008).
A steep climb from the bottom for yield spread
The level of the two-/10-year yield spread across global sovereign markets over the past two Fridays.
The exhibit above plots the difference between two-year and 10-year bonds across global sovereign bonds’ yield curves. To better contextualize the level of term structure in reversion, and how quickly it reversed, recall that the policy-rate target in the U.S. hit 50 basis points almost exactly one year ago, on March 20, 2022. Note that the level of curve inversion in both U.S. and German (EUR-denominated) markets was effectively cut in half over a week’s time. The exhibit below is a long-term factor perspective of the same phenomenon. The MSCI Tier 4 MAC Rates Steepener factors represent returns to a strategy that is long short-duration sovereign yields and short long-duration yields.
Steepener-factor returns exceed even those in 2008 and COVID-19 crises
Tier 4 MAC Rates Steepener factor’s returns (yield) across currencies.
Last week’s historic steepener returns — rivaled only by those in past crises or their reversals — coincided with a broad rally in bond prices (drop in yields), though the two-year bond appreciated much more than the long end of the curve. The massive return to the U.S. steepener strategy was driven by this difference in relative performance across the curve. The only comparable episode of sovereign-bond steepening is the October 2022 U.K. gilt crisis, when pension funds were forced sellers of long bonds due to leverage constraints and rapidly rising short rates.
2008 or 2020?
Environments that produce this scale of market volatility in risk-free rates may force investors to make difficult decisions. The most immediate of which may be deciding whether they think today’s market looks like March 2008 or March 2020. Was last week only an omen of volatility yet to come? Or have we just lived through the Silicon Valley tantrum?
Yield Curves: The MSCI Approach (client access only)