Investors may steepen yield curve on fiscal fears

BOND markets remain focused on budget concerns in the United States, euro zone and Japan, meaning the recent pullback in ultra-long sovereign yields may prove short-lived, potentially reigniting interest in this year’s popular curve steepening trade.

Investors have been quick to react to governments that up their spending, or are not seen to be doing enough to rein in their finances, by selling their long-term bonds, pushing borrowing costs for some countries to multi-decade highs.

However, they have shown more leniency towards shorter- dated bonds.

On Monday, ultra-long Japanese bond yields hit record highs and French bond yields neared recent 16-year peaks, while shorter-dated yields rose more modestly, as political turbulence shook markets.

Pressure unlikely to ease in short term

This dynamic, known as curve steepening, has been the runaway trade in the bond market this year.

The gap between 10- and 30-year bond yields in Germany has grown by 36 basis points (bps), while that in US Treasuries has risen 37 bps and in Japan, that gap has increased by around 40 bps.

These spreads reached a peak in early September and have retreated, for now.

“We have been tactically taking profit (on the 10s30s steepener in the United States and euro area), but we still have it,” said Reine Bitar, senior portfolio manager at Amundi.

“That’s simply because we think that the pressure on government budgets is unlikely to resolve quickly,” she added.

The German 10/30 spread is currently around 56 bps, down from 61.5 in early September, but about double what it was a year ago.

Germany, which overhauled its fiscal rules earlier this year to spend more on infrastructure and defence, is expected to raise its budget deficit from 60% to 70% of gross domestic product.

Neighbouring France is embroiled in a political crisis, with its finances a central issue.

A major source of demand for euro-zone debt is also expected to decline, as Dutch pension funds will no longer need to own so many long-dated bonds following a reform to the industry.

In response, national debt agencies in the United States, euro zone, Japan and elsewhere, are working to prevent volatility and weakness in longer-dated bonds by selling debt with shorter maturities and reducing long-dated issuance.

“We still like curve steepeners in both Germany and the United States, though we’ve reduced our exposure as curves have largely normalised,” said Konstantin Veit, portfolio manager at Pimco, who said the steepening so far was also due to shifts in central bank policies.

Morgan Stanley said it still favours 10s30s steepeners, but downplayed the role of heavy German supply as a driving force. Instead, it pointed to the Dutch pension reform and growing expectations of further declines in interest rates at the short end of the curve as more meaningful catalysts.

Risks loom in the US

In the United States, the debate isn’t just about the trajectory of sovereign debt.

There is concern over inflation – even if the current consensus is that tariff-driven price pressures will prove transitory – and over US Federal Reserve (Fed) independence.

Both could fuel a further steepening of the Treasuries curve.

Any perception of the Fed bowing to pressure from President Donald Trump to cut rates more quickly may drive inflation expectations and yields higher.

The view from Pimco, and others, is the US curve reflects an assumption that Fed independence remains intact and that the budget deficit ends up close to the US government’s own forecasts, meaning further steepening might be limited.

“Anything above 110 bps in the 5s30s is a taking profit level,” Amundi’s Bitar added, when asked about thresholds.

The gap between US five- and 30-year yields is currently around 100 bps, having hit a four-year high of 120 bps in early September.

Japan leads in long-end curve steepening

There is investor appetite for ultra-long maturities, even with US debt equivalent to around 120% of gross domestic product (GDP), or Japanese debt, equal to 230% of GDP.

The 10s30s yield gap in Japan is around 160 bps, compared with a modest 55 bps in Germany and 57 bps in the United States.

“Much of the steepening in Japan has been due to a new solvency regime for domestic life insurers who no longer need to own as many long bonds,” Pimco’s Konstantin said.

“The Japanese 10s30s curve not only looks like an outlier in global context, but also well above a fair value based on historical domestic relationships.” — Reuters