The Long End of the Treasury Market Continues to Flatten, Discounting Lower Growth

We've written in the past about the ongoing bull flattening of the long end of the yield curve here and here and how, despite the name, bull flattening is hardly bullish for stocks. We revisit this topic because with today's moves in the bond market (the 10-year yield dropped by 4bps and the 30-year yield dropped by 6bps), the spread between the 30-year bond and the 10-year bond has dropped to the lowest level since the fall of 2009 (chart 1).

So what? Typically bull flattenings are a precursor to rate cuts (hence the "bull" in the term). This time, however, the backdrop could not be more different. Fed is on the cusp of ending QE with the logical next steps of draining excess reserves and raising rates. It therefore likely to be the case that the bond market is discounting structurally slower growth.

How do we know? Since treasury bonds are risk free investments, the yield can be broken down into two components, a real component and an inflation component. A term premium is also assigned to longer dated treasury bonds, but this is typically a comparatively small portion of the yield so we'll ignore it for simplicity sake. As chart 2 below shows, the real (or growth) component as measured by TIPS yields has been falling all year while the inflation component (chart 3) has been anchored. From this we can infer that the majority of the 30-10 spread compression has been due to 30-year real rates falling faster than 10-year real rates. Chart 4 below, which shows the 30-10 spread on TIPS bonds, confirms this.

While stocks have been immune to this phenomenon since the middle of 2013 (chart 5), we have our doubts as to the ability of stocks to ignore the trends in the bond market indefinitely.