The Smoke Thickens In China

A major part of any yield curve is inflation expectations. Nominal growth, particularly toward the longer end of curves, sets the agenda for trading. But further out there are several confluences that may cause distortions. For Economists, these are conundrums.

There are times, however, when curve dynamics remain pretty simple. These are not usually the best of times. As my colleague Joe Calhoun points out, it’s backward in convention. In other words, what Wall Street may call a bull steepener case for the bond market is actually bullish only for those bonds contained within the curve. For everyone else, particularly the macroeconomy, this change works out over time decidedly bearish.

This bear steepener in reality (bull steepener in bond trading) is perfectly clear. The short end drops quickly with the long end following if at a slower rate. Nominally, the whole curve shifts lower but because the short end is moving fast the curve steepens while it shrinks. Traditionally, this is the recession signal.

If curve inversion suggests a good probability of economic contraction ahead, this bear steepener indicates that it’s close or even already arrived. The short end falls largely because of authorities panic and begin the frenzied process of reducing benchmarks and such or just trying to flood money markets with what they perceive as excess liquidity in the hopes of somehow staving off the looming macro bear turn.

For most of the last year, everyone has been paying close attention to the UST curve for these same alarms. So far, treasuries have only threatened inversion. The bull steepener, therefore, remains only a possible future association.

Other global curves, however, are in varying stages further along. Most importantly, China’s federal bond curve inverted at several times last year. And since the RRR cuts particularly the latest this year, money rates have recently plunged. The net result, since short-term government bonds are treated as close money substitutes, is a Chinese yield curve that last year inverted and now clearly displays the bear steepener case.