Inflation Fears Fuel The Bear Steepener

Recent market events, including Fed Chair Powell's Jackson Hole speech, are signaling a significant yield curve steepening, specifically a 'bear steepener,' driven by rising inflation expectations. Analysis of Fed Funds futures, 5Y/5Y forwards, and CPI swaps suggests inflation is being underpriced, while technical indicators show the 30-year Treasury nearing a breakout above 5.1%. Key spreads, such as the 30-year minus 2-year Treasury, are widening significantly, already at their widest since January 2022 and poised for further expansion. This implies that the steepening will primarily be driven by rising long-term rates, indicating that the bear steepener is now in motion.

Analysis

A bear steepening of the U.S. Treasury yield curve appears to be in motion, driven primarily by rising inflation expectations following recent Federal Reserve commentary. Inflationary pressures are evidenced by 5Y/5Y forward inflation breakevens and 5-Year CPI swaps, both of which are trading at the upper end of their recent ranges. This trend suggests that market pricing for future Fed Funds rate cuts, which currently anticipates a bottom around 3%, may be too aggressive, thereby limiting the potential for a significant rally at the front end of the curve. The steepening is therefore expected to be led by a rise in long-term yields. This view is supported by technical analysis, which shows the 30-year Treasury yield nearing a breakout from an ascending triangle pattern, a move that would push it above the previous high of 5.1%. Correspondingly, the iShares 20+ Year Treasury Bond ETF (TLT) exhibits a bearish descending triangle, signaling a potential decline below its $83 support level. Key spreads are already widening, with the 30-year minus 2-year spread breaking resistance at 1.25%, its widest level since January 2022, and positioned to potentially expand by another 25 to 50 basis points.

Key Decisions for Investors

• Investors should consider positioning for a bear steepener, which could involve shorting long-duration Treasury instruments or utilizing spread trades that would profit from a widening gap between long-term and short-term rates.
• Given the bearish descending triangle pattern and strongly negative sentiment for the iShares 20+ Year Treasury Bond ETF (TLT), it may be prudent to reduce long exposure or consider establishing short positions, particularly if the ETF breaks below its key $83 support level.
• Monitor forward inflation indicators, such as 5Y/5Y breakevens, as a sustained rise would validate the thesis for higher long-term yields and could force markets to price out anticipated Fed rate cuts.
• A confirmed technical breakout in the 30-year Treasury yield above 5.1% should be viewed as a significant signal that could accelerate the sell-off in long-duration bonds and further drive the bear steepening dynamic.