Bull Flattener


What is a Bull Flattener?

A bullish flattening is a rate-of-return environment in which long-term rates are declining faster than short-term rates. That causes the yield curve to flatten as short-term and long-term rates begin to converge.

KEY TIPS

  • A bullish flattening is a rate-of-return environment in which long-term rates are declining faster than short-term rates.
  • In the short term, a bullish flattening is a bullish signal that is generally followed by higher stock prices and economic prosperity.
  • In the long term, a bullish flattening often leads to lower yields for bonds and stocks.

How a bull flattener works

The yield curve is a graph that plots the yields of bonds of similar quality against their maturities, ranging from shortest to longest. Yield curves are typically constructed using US Treasury securities.The yield curve shows the yields on bonds with maturities ranging from 3 months to 30 years. In a normal interest rate environment, the curve slopes up from left to right. Bonds with short maturities generally have lower yields than bonds with long maturities because they have lower interest rate risk.

Different factors influence the short and long ends of the yield curve. The short end of the yield curve as a function of short-term interest rates is determined by the expectations of the Federal Reserve’s policy regarding rates. The short part rises when the Fed is expected to raise rates and falls when investors anticipate interest rate cuts. The long end of the yield curve is influenced by factors such as the inflation outlook, investor demand, the federal budget deficit, and projected economic growth.

The yield curve can steep or flatten. When the yield curve steepens, the spread between short-term and long-term interest rates widens, making the curve appear steeper. A flattened yield curve, on the other hand, occurs when the spread between the long- and short-term interest rates on bonds decreases. A smasher can be a bear smasher or a bull smasher.

In an upward flattening, long-term interest rates fall faster than short-term interest rates, making the yield curve flatter. When the yield curve flattens as a result of short-term interest rates rising faster than long-term interest rates, it is a bearish flattening. This change in the yield curve often precedes the Fed’s rise in short-term interest rates, which is bearish for both the economy and the stock market.

Advantages of a Bull Flattener

A bullish flattening is considered a bullish indicator for the economy. It could indicate that investors expect inflation to fall in the long term, leading to comparatively lower long-term rates. If the prediction of lower long-term inflation comes true, the Fed has more room to cut short-term interest rates. When the Fed lowers rates in the short term, it is generally considered bullish for both the economy and the stock market. There could also be a bullish flattening as more investors choose long-term bonds compared to short-term bonds, driving up long-term bond prices and lowering yields.

A bullish flattening is often, but not always, followed by gains in the stock market and growth in the economy.

Disadvantages of a Bull Flattener

While a bullish flattening is usually bullish for most of the economy in the short term, the long-term effects are quite different. A bullish flattening is often driven by falling interest rates, which directly increase bond prices and short-term yields. However, higher bond prices mean lower yields and lower bond yields in the future. It is precisely those lower expected returns on bonds that drive investors to enter the stock market. That raises stock prices in the short term, but higher stock prices mean lower dividend yields and lower returns for long-term stocks.

An upward flattening can even occur because expected long-term growth, rather than inflation, declined. However, that is rare because economic growth is much more stable and predictable than inflation.

Example of a Bull Flattener

When long-term bond yields fall faster than short-term bond interest rates, interest rates begin to converge in a normal rate environment. Convergence, in turn, flattens the yield curve when plotted on a graph. Suppose two-year Treasury bonds yield 2.07% and 10-year Treasury bonds yield 2.85% on February 9. On March 10, the two-year Treasury bonds yield 2.05%, while the ten-year Treasury bonds yield 2.35%. The difference went from 78 basis points to 30 basis points, so the yield curve flattened. The flattening came about because the long end, the 10-year Treasury, fell 50 basis points compared to the 2-basis point drop at the short end, the two-year Treasury. Long-term rates fell faster than short-term rates, so it was a bullish flattening.

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Mark Holland

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