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The bond market is about to cross a 'line in the sand'

Desert camels line in the sand
Desert camels line in the sand

(Camels resting in sand dunes on a sunset ride in Erg Chebbi, Morocco, at the edge of the Saharan desert.AP/Giovanna Dell’Orto)

Bond yields remain abnormally low across much of the developed world as policies of zero or even negative interest rates by the Bank of England, the Bank of Japan, the European Central Bank, and the US Federal Reserve keep rates anchored.

That has kept the yield curve, which measures the difference between short-term rates and long-term rates, relatively flat even though some expect the Fed to raise rates again later this year.

According to Citi's Technicals team, led by Tom Fitzpatrick, the spread between the US two-year yield and the US five-year yield is going to flatten further, and the current level of about 35 basis points is the "line in the sand."

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In other words, the yield curve is about to breach a crucial support level. That would normally trigger a "WHAT?"

Research from Citi shows that the three most recent breakdowns of that level produced a move lower to at least 11 basis points. And the yield curve eventually inverted, though in the case of the 1994 breakdown an inversion didn't occur until the end of 1997.

Typically, when the yield curve inverts, it signals that a "negative economic/market event" has happened and that a recession is ahead.

2Y 5Y spread
2Y 5Y spread

(Citi)

Citi, however, says this time around is different and the narrative that a flattening yield curve is a negative for the US economy is "completely wrong."

That thought process seems to go along with what others in the industry are saying.

At a round-table discussion in July, Mohamed El-Erian, Allianz's chief economic adviser, told reporters: "If we were living in a normal world, that would be a massive signal of recession, it's so flat, and at rates so low, that the only conclusion you could normally devise from the yield curve is that we are on the cusp of a major recession," but what's pulling down the yield curve, he said, "has less to do with the US and has more to do with Europe."

Citi does warn, however, that there is a point at which it will begin to get worried. That is if the curve inverts by about 20 basis points. Then we might have problem, as the instances in 1989, 2000, and 2006 instances were all a harbinger of "bad things to come."

And while the shape of the yield curve is important, Citi's Technicals team says what is even more important is the type of flattening that occurs. Those scenarios include:

  1. Bear flattening, or the yield curve flattening as Treasurys sell off, causing yields to move higher. This occurrence would mean the shorter-term yield rises faster than the longer-term yield. Citi says this would happen if the market felt the Fed was going to start raising rates again. It believes something like this could happen in December.

  2. Bull flattening, or the yield curve flattening as Treasurys catch a bid, causing yields to fall. In this instance, the longer-term yield would fall faster than shorter-term yield. Citi believes this is unlikely to happen, however, as it would most likely occur if the Fed were to launch another round of quantitative easing or if foreign investors continued to play the long end as a play on rate differentials.

  3. "Hybrid flattening," or short-term yields rise as long-term yields lag or even fall. According to Citi, "This is predominately a demand/supply driven dynamic where increased demand for value in the long end of the US curve is not matched by supply."

As for how this eventually plays out, the team thinks this week's Jackson Hole Symposium could lead the market to believe that a Fed rate hike won't happen before the end of the year and that bull flattening will win out in the near-term. But that could turn into a hybrid flattening before eventually seeing bear flattening.

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