Market Hinting a Bull-Flattening Cycle

The economy has recovered and just recently has been putting on the brakes, it's time to expect a bull flattening cycle in the bond markets. It's not only a secular thing that happens when the economy is in a slump it's mechanically going to happen based on the actions of the central bank.

One way to understand bull-flattening is to take the point of view of a bank who is no longer able to borrow and short-term rates and lend at longer term rates. Typically, banks are able to profit in normal bond bull markets this way, by lending at low rates and lending at higher rates. However, we are not in a typical scenario so the bond market is showing a atypical steepened scenario with the short-term rates near zero and the 30 year bond above 4%. That's very steep considering the projection for economic growth is moderate at best.

Mechanically, the central bank has implied that quantitative easing programs QE1 and QE2 have artificially steepened the yield curve.

Estimates based on a number of recent studies as well as Federal Reserve analyses suggest that, all else being equal, the second round of asset purchases probably lowered longer-term interest rates approximately 10 to 30 basis points.³ Our analysis further indicates that a reduction in longer-term interest rates of this magnitude would be roughly equivalent in terms of its effect on the economy to a 40 to 120 basis point reduction in the federal funds rate. 

The last quote was pulled from the central bank testimony by chairman Ben Bernanke. Esentially, it implies that mechanically the quantitative easing has been lowering rates on an even scale. More of the long-term treasuries have been  less effected than the short-term treasuries. With that said the unwinding of these programs should continue to flatten the yield coinciding an already secular move towards a bull-flattening cycle.