Rates, Curve Steepener and Bear Steepener

Remedies for the symptoms

Clearly, U.S. debt must be remedied. Political solutions, more than financial ones, tend to work when the market does not price the adjustment and sovereign political actors do not yield in their demands.

But political actors insist on intervening by other means, in this case apparently trying to lower rates.

A first attempt was to directly lower the rate via the Fed. Attacks on the Fed’s independence, including the investigation of J. Powell and the White House’s setback in the SCOTUS, were a clear threat aimed at reducing short rates.

Regardless of the legal issues above, the financial idea behind this is the theory that tells us a long-term bond’s rate is composed of the average of short rates expected by investors, on the one hand, and the term premium, on the other (important for what we will say below about the Bear Steepener strategy).

Discarding the Quantitative Easing (QE) strategy, unattractive for the current Fed, the Fed could indeed move long rates in a scenario with (i) forward guidance, which is being sought to be reformed and consists of communicating a commitment to keep short rates low for an extended period (considering that the sum of those rates tends to determine long rates); (ii) anchoring the neutral rate, considering that long rates reflect the long-term neutral rate, via the Dot Plot or the corresponding projection instrument, conveying to the market the Fed’s belief about where the rate will be in the future (downward); (iii) portfolio rebalancing, through an aggressive cut in the federal funds rate (IORB or REPO -ON RRP-), which will reduce the return on cash and Treasury bills (short-duration debt), seeking the “crowding-out” effect, ensuring institutions move toward longer-duration instruments (with more attractive yields), that is, long-term bonds (increasing their demand, raising their price and lowering their yield); (iv) and Operation Twist, which is similar to QE but sterilized, disposing of short-term securities and repurchasing long-term ones (reduces the term premium by compressing it through demand).

This topic deserves full analysis, which we will not deepen on this occasion. Just note that all financial operators take independence as a baseline scenario, and notwithstanding that the Fed in granular analysis has room to move in a given direction, together with the timing of those moves, we all assume the law will be followed: the inflation mandate (considering its dual mandate).

A second attempt was somewhat less forced. Banking regulatory easing to allow these types of institutions to hold more (U.S.) bonds on their balance sheets. Rules on the Supplementary Leverage Ratio for GSIBs (global systemically important banks), in banking law, have a relatively simple treatment, since they are rules with little sensitivity to the risk of the assets they regulate, that is, they do not include risk-weighted assets. For example, Treasury bonds are treated the same as a synthetic in these rules when calculating the ratio. Generally the ratio was a fixed minimum, made up of base risk and an add-on amortization.

In general, ratios are guided either by (i) the institution’s leverage, or (ii) the risk of its assets. We are moving from the former to the latter.

Flexibility is sought to operate with safer assets (long Treasuries if held to maturity), to the detriment of riskier ones. And, with this flexibility, balances grow without the need for new capital requirements.

Now, this has a nuance between subsidiaries and banking holdings. It is for the former that the leverage ratio matters, even considering that it can create incentives pushing them toward riskier assets, because leverage ratios (unlike risk-based ratios) are insensitive to asset risk, so capital requirements do not increase under that criterion. And it is in this case where the easing we are discussing causes the most concern.

Thus, the constraint on holding Treasuries, and their repo operations, was represented in regulation by the leverage ratio, insensitive to risk. And although there is a difference between trading positions and holdings for investment of these instruments, in both cases it would theoretically be possible to increase trading in them through this easing.

The flexibility driven by the FDIC, Fed and OCC did increase the liquidity of these instruments, helping to fix prices more quickly; it raised the share prices of large banks by requiring less capital; but apparently it did not substantially increase demand for bonds to lower long rates.

We can also include among these attempts to lower rates, besides those already mentioned, currency interventions in Japan and Argentina; the reduction in issuance of long bonds to increase those on the short end of the curve; and the enactment of the GENIUS Act (on stablecoins), which orders backing issuances with Treasury. We will not analyze this, but they point to the same thing: lowering long rates or increasing demand for bonds.

Bond repurchases

When things don’t work it means they are not right, they failed. And if there are futures on that, it is also possible to get ahead and know if you failed before expected. That is what we might be seeing in this other attempt to calibrate U.S. debt. But there is room to know whether the strategy worked in part or not.

What we know is that this strategy can have a different ending than intended, leading to a requirement for higher returns on long-term bonds (term premium as noted above). The government’s idea was effective in lowering yields at first, but it does not serve the main cause, that is, reducing the deficit in an economy at full employment, and at war.

The greatest risk is that the market loses credibility in these kinds of actions, which are becoming very common as we saw. The point is that this market is recognized for being extremely orderly, especially in quantity and periodicity. It is one of the most predictable and regular markets.

Since the war, inflation, and the reactivation of debt (due to AI) in capital markets, long-term rates have continued to rise. That is worrying, especially for the U.S. government. Each rise in rates is one more unit to reallocate investment to fixed income, moving us away from riskier assets. This increases the cost of capital to continue the AI rally.

But clearly this act is quite strange and surprising, especially when the issuance and repurchase calendar was already set. The rationale was apparently political.

Fiscal policy is limited by monetary policy. There are no easy decisions here. We know when this limit, even legal, is not respected. Think, if you are Latin American, of Argentina; if American or European, of the Turkish lira. The prices of budgetary libertinism will be reflected sooner or later in the price, in the rate. And to that we must add currency weakening.

Amid this, with these deficits, the dollar remains a currency without replacement. And the cost of corporate debt remains low. This is usually due to corporate debt spreads relative to Treasury yields. The justification for this optimistic scenario is that the market is worried about inflation, not default. The possibility of U.S. sovereign default has never been priced in the rate, because it does not exist (or did not exist until now). But even if that scenario persists, since the U.S. remains sound, when the market stops worrying about inflation, central banks will take measures, and the default risk will be priced in.

Also, when these state intervention operations are assembled, the signal is a single one: nothing will change. The current U.S. government will continue spending.

We believe all this is a political, anomalous, infrequent matter and it is a new challenge: politically instrumentalizing the bond market. The market accepted for many years, via the rate as a reflection, the debt and its lax growth. But now that the market began to discount this, the Government sees a problem. And when the State wants a lower rate but the market does not want that rate, we have the real problem. Thus, what we see so far is that the U.S. wants to convince its counterpart, the market, with a non-commercial rate.

Scenario

The financial diagnosis, in this scenario, we believe should respect the following scheme.

Equities. The Fed’s policy rates have always been important for different industries. However, today expectations are completely different, because the infrastructure humanity builds discounts existentially that its profitability will far exceed its costs. The expectation and its strategic necessity make this AI spending indifferent to rates. The main channel to transmit monetary policy against inflation has thus been paralyzed. At least for now.

This last argument could justify maintaining a position in equities, with optimism ahead.

Fixed income. Within scenarios it is possible to see a jump in long rates. This change would lead to a Bear Steepener. This begins by considering the yield curve (interest rates at different maturities, from months to 30 years) of bonds, which allows us to extract information about market expectations regarding future interest rates. This Bear Steepener scenario entails an increase in the spread between long and short rates. It can be the short end falling faster than the long, or the long rate rising faster than the short (the scenario we believe will configure). We thus see a chart where yields rise and bond prices fall (hence the name).

This scenario usually forms when a central bank rate hike is expected, an overheating economy, or—as we believe now—a greater required return reflected in the term premium (fiscal spending). Short rates are determined by monetary policy, long rates by market expectations.

The important thing is that the market will demand higher yields on the long end of the curve compared with short rates.

Curve Steepener

The rate rises, the price falls. That is the rule for bonds. In a scenario where the general rise in rates lowers bond prices, for this strategy there must be an expectation that the spread between long and short rates will widen, making the yield curve steeper.

These strategies are directional and seek to profit from the spread between long and short rates. They involve two simultaneous positions.

On the one hand, short selling the long part of the curve (10- or 30-year bonds). Since we expect long-term rates to rise, the bond price will fall. The short position allows us to profit from the collapse.

On the other hand, buying the short part of the curve (2-year bonds). Short-term rates will rise less, so the bond price will fall less, protecting that part of the portfolio.

We can use the liquidity of the first to finance the second operation. In doing so, it is necessary to adjust the trade to neutralize duration. We know long-term bonds are more sensitive to rate changes (higher duration), so the two operations are not parity if financed crosswise. It will require buying a larger quantity of short bonds compared to the sale of long ones.

Keep in mind that these operations are usually traded with interest rate swaps or futures.

Finally, the risk is the short rate, because if the Fed raises them aggressively, this operation would produce significant losses.