Bull flattening may sound like an exotic, and rather cruel, sport, but for today’s bond investor, it describes an investment opportunity. Some juicy bear flattening is also available, although it comes with somewhat more risk.
The flattening refers to shifts in yields “along the curve,” as they say in the trade. The gap between the yields of two-year and ten-year sovereign debt has been narrowing for several major issuers. In Germany, the so-called 2/10 spread has fallen from 174 basis points in January to 98 basis points, the lowest since 2008. The decline in the UK over the same period is from 249 to 168 basis points. In the United States, it is from 265 to 194 basis points.
The reasons for these shifts couldn’t be more different. In the U.S. and the UK, shorter-dated bond yields are rising faster than longer-dated ones. This occurs when official policy rate rises are expected, because the economy is performing better. It is referred to as a bear flattening.
In Germany, though, there is a bull flattening: longer-dated yields are falling more than short-dated ones. Investors look at the economic news, which is depressing. They contemplate yields on debt with shorter maturities, which are low – recently below zero on two-year paper. Knowing the European Central Bank wants to keep rates low for a while, investors turn to longer maturities, pushing their yields down. These yields are already at record lows, but at least they are still positive.
Barring economic shocks, both the bull and bear flattening are likely to keep going. But the trend is less certain in the UK and America. In both countries, wages aren’t picking up as quickly as expected, despite falling unemployment. If monetary policymakers defer rate rises, the yield curve flattening in these countries could pause for a while. Or if inflation picks up more than expected, yields on their longer-term debt could rise more quickly than has so far been the case.
The German opportunity looks safer. Inflation and economic activity are feeble, and the European Central Bank has promised to do something to help. Betting on a bit of German bull flattening might be just the thing.