BOND REPORT: Steepening Yield Curve Slams One Of The Bond Market's Biggest Bets

A selloff in Treasuries has left market participants guessing if the yield curve will continue to flatten

One of the biggest trades in the bond market has hit a painful pause after the so-called yield curve steepened this week.

In the past few months, the widely accepted story that an overly aggressive Federal Reserve would hike interest rates, even as inflation remained lackluster, has helped flatten the yield curve, a graph tracing a bond's maturities and its yields. Long-dated yields would remain depressed, thanks to weak inflation expectations, and short-dated yields would rise on anticipation that the central bank is set to raise rates two to three times next year.

See: Here's how the Fed is flattening the yield curve (http://www.marketwatch.com/story/heres-how-the-fed-is-flattening-the-yield-curve-2017-10-18)

Investors were comfortable with this narrative, with brokers and analysts saying the yield curve was ultimately going to invert as soon as 2018. The moment when short-dated yields are higher than their long-dated counterparts is often seen as a precursor to a recession.

Read: Why the yield curve flattening -- a recession red flag -- is the 'real deal' (http://www.marketwatch.com/story/why-the-yield-curve-flattening-is-the-real-deal-2017-12-15)

But in three days, investor sentiment turned on a dime after a selloff in the bond market lifted long-term Treasury yields and steepened the yield curve. Bond prices fall when yields rise.

The spread between the 10-year Treasury yield and the two-year Treasury yield , a common measure of the yield curve's slope, widened 13 basis points to 0.64 percentage points since Monday after touching a decade-long low of 0.51 percentage points last Friday.

That caused traders to second-guess what was previously seen as a surefire bet. A Bank of Merrill Lynch investor survey found that a net 8% of those polled expected the yield curve to flatten in 2018, the highest level since last June.

Caught off-side, speculators are likely to be hurting, especially if they had added leverage to their wagers. Hedge funds that use debt to increase the returns from their trades are often compelled to exit their wagers to avoid crunching losses. The amount of bullish bets that exceeded bearish ones on 30-year Treasury bond futures hit 100,910 as of Dec. 12, their highest levels since July 2016, according to data from the Commodity Futures Trading Commission.

"It's a heavy trade, so it's going to cause some pain," said Marvin Loh, senior fixed-income strategist at BNY Mellon.

Analysts are divided on whether this steepening signals a sea-change in sentiment or a breather for the yield curve based on a few days of trading. After all, though the 10-year Treasury yield touched 2.50% on Wednesday, it remains well within its yearlong trading range.

"There is no real breakout, and despite all the animal spirits out there and pro-cyclical narrative, the current yield is not altogether that far off from the average and median for this time of year going back to 2009," wrote Dave Rosenberg, chief economist for Gluskin Sheff.

The speed and strength of the move has nonetheless prompted Wall street analysts to come up with a gamut of reasons for the sudden shift in investor sentiment. Loh described the scramble to find a plausible explanation for what feels like an inexplicable selloff as "curve-fitting."

One oft-cited reason was synchronized global growth that should prompt easing central banks to shift away from their ultra-accommodative monetary policies. Others point out that trading desks thinned out by falling revenues will have to deal with a deluge of supply next year.

And as the selloff in Treasurys has coincided with the tax bill's rapid approval, many have sought to blame the legislation for the recent steepening. With the economy late into its expansion, further fiscal stimulus could prove inflationary, with dwindling slack in the economy and the labor market.

Also check out: Historic tax overhaul heads to Trump for signature (http://www.marketwatch.com/story/historic-tax-overhaul-heads-to-trump-for-signature-2017-12-20)

"This could be the start of a bigger move -- a lot of it hinges on D.C. passing the tax plan as the bond market has been skeptical -- fiscal policy at this stage is inflationary and the bond market is about to find out and that will challenge those in broader curve flatteners," said George Goncalves, head of U.S. rates strategy for Nomura.

In addition, the tax cuts are not expected to produce enough growth to mitigate the fall in tax receipts, forcing the Treasury Department to borrow what it can't get from taxpayers. Combine the increase in debt supply for next year with the Fed's retreat from its bond-buying operations, and it's difficult to see who will pick up the slack, analysts said.

Net issuance of government debt is expected to $1.3 trillion, according to forecasts by JPMorgan Chase & Co.

Market participants had already raised the odds of the tax bill's passage before this week, yet the reaction in Treasurys was muted.

As confusion reigns over the bond market, if only for a fleeting moment, investors are unlikely to bet against the steepening yield curve anytime soon.

"We're certainly content to attribute some of the severity of the price action to an unwillingness to stand in front of the selloff ahead of year-end -- catching a falling knife and all," wrote Ian Lygen, head of U.S. rates strategy for BMO Capital Markets.

(END) Dow Jones Newswires

December 23, 2017 12:42 ET (17:42 GMT)