Investors in U.S. government bonds could face serious pain if the Federal Reserve tries to steepen the so-called yield curve.
Thats according to Mark Holman, a bond fund manager at TwentyFour Asset Management, who says Treasurys were vulnerable to a change in Fed communications amid increasingly publicly voiced concerns among U.S. central bankers over the flatness of the yield curve, hurting investors who had piled into Treasurys as a haven from market volatility.
The Fed is one decision away from steepening the yield curve, said Holman, who says if monetary policymakers ease away from forward guidance it could add uncertainty to investors forecasts for future rate hikes, pushing investors to demand higher yields for owning longer-dated bonds.
A flattening curve, and a narrower spread between short-dated yields and long-dated yields, is read as a sign of concern about future economic growth, though it is an outright inversion of the curve with short-dated yields moving above long-dated yields that serves as a reliable recession warning sign. The curve tends to flatten when the Fed hikes rates, but the bond market indicator usually widens when the central bank eases on its hiking plans.
Read: How the Fed decides if the economy is headed to a recession
Investors have already had a taster of the Feds commentary. The 10-year Treasury note
climbed to a seven-year high of 3.011%, widening the spread between the 2-year note yield
and the 10-year note yield to 54 basis points from the prerecession low of 43 basis points hit last Thursday, according to Tradeweb data. Bond prices fall when yields rise.
The bond market selloff coincided with comments made by St. Louis Fed President James Bullard and San Francisco Fed President John Williams this week who said the justification for forward guidance is waning as the central bank approaches the long-term neutral rate, the interest rate at which monetary policy neither stimulates nor retards growth.
The central banks’ dot plot suggests the neutral rate lies at 2.50 to 2.75%. If the Fed sticks to its rate hike path of three rate increases this year and the following year, the yield curve should have inverted by the end of 2019. The dot plot shows where senior Fed officials expect future interest rates to end up.
Atlanta Fed President Raphael Bostic even went so far as to say on Wednesday that it was his job to avoid a yield curve inversion.
That could be painful for traders who are betting on the yield curve to keep flattening as Bostic may reflexively turn more dovish as the curve nears inversion, said Aaron Kohli, fixed-income strategist for BMO Capital Markets, in a note dated on Wednesday.
Another way the Fed could send longer-dated yi