Steepening

Steepening shows how a yield curve changes when the spread between short-term and long-term yields of a financial instrument (bonds, treasury bonds, etc.) increases. For investors, it indicates that inflation may rise, and economic growth may increase. Potential butterfly shifts and flattening in this curve are further considerations while evaluating the state of an economy.

It represents changes in long-term bond value compared to short-term bonds, which may decrease depending on specific yield movements. Banks usually benefit from it as they can lend at higher long-term rates and secure credit at lower short-term rates. Other things like economic conditions, credit risk, etc., may impact banks. It also depicts the cost of borrowing money across various time durations.

• Steepening means a change in the yield curve during a period when the gap between the long-term and short-term yields widens.
• It indicates an increase in both yields, long-term and short-term. However, long-term yields increase faster than short-term ones. It depicts the possibility of a rise in inflation and significant economic growth.
• A steepening yield curve graph shows an increasing gap between short-term and long-term interest rates, reflecting economic expectations and interest rate changes.
• Bear steepeners negatively impact markets due to inflation and rate increases, while Bull steepeners usually have a positive impact due to potential economic growth.

Steepening of the yield curve is defined as the widening of the spread between long-term and short-term interest rates, resulting in a steeper slope formation on the yield curve. It indicates a long-term interest rate hike is faster than a short-term one. It happens because of economic conditions, changing market expectations, and monetary policy.

In general, it is considered a symbol of economic expansion and represents positivity in the market. However, it must be noted that excessive steepening can have negative effects, like an uncontrolled rise in borrowing costs.

It has significant implications for investors and can assist investors in interpreting market and economic conditions. Let us study them.

• Investors should revisit their investment strategies as and when the yield curve changes. Depending on which yield looks promising in a given period, investors should select from short-term and long-term bonds.
• It facilitates economic development since the overall investment ecosystem looks poised to offer positive returns.
• It offers opportunities for investments in long-term assets. It must be noted that risks may simultaneously increase.
• It may lead to bearish results in equity markets since investors find fixed-income securities more attractive.
• One of the risks is a slowdown due to rising long-term interest rates.
• It may compel investors to sell equities in hoards.
• It might influence capital flows and the performance of various asset classes.

With all the points listed above, individual circumstances must be considered before making a decision.

Bearish and bullish steepeners are the two types of steepening effects. Their impact on the markets and the economy is different. Bearish steepeners, considered unfavorable for growth, occur when long-term rates increase faster than short-term rates. It indicates that inflationary pressures are a possibility, in addition to other economic factors, and the Federal Reserve (Fed) might increase interest rates to tackle probable issues. Bullish steepeners act the other way around, with short-term interest rates declining more rapidly than long-term rates.

One must always remember to consider that policymaking, global economic conditions, and investor sentiment, among other things, play their respective roles in shaping the results.

A yield curve represents the interconnection between maturities and bond yields. However, a steepening yield curve can be observed when the distance between long-term and short-term rates broadens either due to long-term rates increasing speedily or short-term rates falling rapidly.

Irrespective of the movement at the long or short end of the curve, it provides detailed information about interest rate changes and the market's anticipation of upcoming changes in the economy. Moreover, there is always an inverse relationship between yield and price.

Butterfly shifts and flattening depict on graphs how these changes take place. Butterfly shifts refer to shifts in a yield curve where changes take place more in the medium-term than short- or long-term yields. Flattening occurs when long-term yields fall more than short-term ones.

Therefore, the steepening yield curve graph above shows the growing difference between long- and short-term rates per market and economic expectations for a bond curve steepening.

Investment, borrowing, and other business decisions may be affected by it. Let us study some examples in this section.

Example #1

Suppose Cathy is an investor with two security instruments, A and B. They have different tenures and interest rates. Instrument A is a three-year note with a 3% interest rate. Instrument B is a twenty-year-old note with a 3.2 % interest rate. The difference between the interest rates of A and B goes from 1 % to 1.10 % points, steepening the curve.

This indicates potential economic growth and rising inflation; a phenomenon called the steepening trade. However, whether this occurs in reality depends on several other factors, like overall market conditions and Cathy’s risk tolerance.

Let us see what could happen in Cathy’s situation.

• The three-year note’s price might decline as and when new notes become available to investors. Hence, investors will prefer investing in new notes, and Cathy’s fixed-income security will lose its initial value.
• Interest rate changes will likely affect the price of Instrument B. Hence, a steepening curve might result in a price decline.

Ideally, Cathay must make investment decisions based on comprehensive economic data, central bank decisions, the Federal Reserve’s outlook, and global economic changes. While Cathy can rely on the effects of such steepeners, it is advisable to seek professional assistance.

Example #2

A February 2024 article published online discusses the yield curve steepening of the treasury bill exchange-traded fund (ETF) Bill Index (BIL). Treasury Bill ETF BIL has remained an asset with an excellent risk-reward profile, with a yield curve of more than 5% and almost no risk. Its yield curve depicts steadily rising interest rates, with a 75 basis points (bps) drop seen across a short-term curve.

In such a scenario, when the earnings yield of the S&P 500 is lower than treasury bonds, it is deemed a loss-making investment. With the yield curve being in its inverted state, there is no expectation of a favorable return from long-term stocks and bonds. In this situation, BIL offers returns higher than the S&P 500 at minimal risk, making it popular among investors.

In this manner, investors can analyze situations based on what kind of a yield curve steepener is seen in an economy.

Bear and bull steepeners have different effects on an economy and central bank regulations. Let us study them in the table below.

This article has been a guide to Steepening and its meaning. We explain the concept with its yield curve, examples, and a comparison between bear & bull steepening. You may also find some useful articles here -

• Flat Yield Curve
• Bootstrapping Yield Curve
• Normal Yield Curve