Searching for Economic Optimism: Analyzing the Curve-Steepening Phenomenon in Interest Rate Markets

Rates Spark: In search of that curve-steepening optimism

At this stage of the cycle, curve steepening tends to occur when short rates drop. This makes last week’s bear-steepening all the more noticeable. We think the economic optimism required for long-end rates to catch up to the front-end is missing. Today’s Zew should confirm that.

 

Curve steepening in a hiking cycle is typically caused by falling front-end rates

There was a pretty noticeable turnaround of the curve-flattening theme last week. Flattening has dominated interest rate markets since it became evident that central banks needed to tighten policy to fight the inflation surge. This is not the first time the curve has re-steepened in this cycle. The last such steepening, in March this year, as investors fretted about the risk of a banking crisis in the US, was caused by a reassessment of the near-term path for policy. In other words, it was caused by a plunge in short-term yields. Previous occurrences in this tightening cycle fit that mould and, each time, the move has been promptly reversed.

 

Last week’s curve steepening differs in that it was largely driven by higher long-end yields. If the move extends, it will be a departure from the trend in place since early 2021 in the US and early 2022 in the eurozone. This would be more than a mere technicality. What rates specialists call a bear-steepening of the curve, put more simply is a rise in long-end yields. For instance, for the 2s10s US Treasury curve to bear-steepen back to flat, from over 100bp inverted at the start of the month, the 10Y would need to rise to almost 5%, from just above 4% currently. This would be a significant improvement in the transmission of tighter monetary policy which has struggled to propagate fully to longer-dated forms of borrowing, and a sure drag on the economy.

 

Unlike previous steepening episodes, last week's wasn't caused by a fall in front-end rates

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