Curve Flattening
29 September 2021
Yield curve flattening
Since May, the U.S. yield curve has been flattening, i.e., the yield differential between long and short maturities is narrower. This spread measures the term premium, or the compensation investors demand to own long-dated bonds.
- The top chart shows the 5y30y spread.
- A high (low) spread indicates a high (low) term premium.
Duration is more significant than inflation or credit risks
The premium investors demand to hold long-dated bonds, rather than rolling short-dated bonds, is referred to as term premium. It is related to inflation risk, credit risk, and real duration risk. As inflation expectations declined across the entire curve and credit risk did not move, the recent move in premium can be fully ascribed to real duration risk change.
- The bottom chart shows how the 5y real rates increased ~20 bps, while the 30y real rates dropped ~45bp, totaling a ~65bps differential.
What are bonds saying?
A slowing economy reduces the real duration risk, leading bond investors to demand less term premium, hence the flattening.
- This flattening also suggests the bond market is not pricing any sustained period of high inflation or tapering that would strongly tighten financial conditions.
- A slowing economy may not be such a bad scenario for equities.
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