Why bonds will settle between 6 and 7 percent. Credit Markets 101: It is all about the term structure, stupid!

The term structure of interest rates, often represented by the yield curve, is the relationship between the interest rate (or cost of borrowing) and the time to maturity of the debt. The shape of the yield curve conveys much information about market expectations for future interest rates and economic activity. Over time, several common term structure regimes or shapes of the yield curve have been identified:

Normal (Upward Sloping) Yield Curve

This is the most common shape for the yield curve. Short-term bond yields are lower than long-term bond yields. This shape indicates that the market expects the economy to grow in the future, and there's an anticipation of rising interest rates. The curve can be steep or gently sloping depending on the magnitude of the rate difference over the term structure.

Inverted (or Downward Sloping) Yield Curve

In this regime, short-term bond yields are higher than long-term bond yields. This is less common and is often seen as a predictor of an upcoming recession. An inverted yield curve suggests that the market expects interest rates to fall in the future, which typically happens in response to an economic slowdown.

Flat Yield Curve

Here, short-term and long-term yields are close to each other. This might be seen during transitions when the yield curve moves from normal to inverted or vice-versa. Sometimes, a flat curve may suggest that the market expects interest rates to remain relatively stable.

Humped or Bell-Shaped Curve

In this regime, the yields for intermediate-term maturities are higher than both short-term and long-term maturities. This shape is rare and can indicate uncertainty in the market.

Steep Yield Curve

This is a variation of the normal yield curve but with a pronounced difference between short-term and long-term rates. A steep yield curve might occur after a period of significant monetary easing. It indicates that while the current short-term rates are low, the market expects higher rates.

The following applies to assuming we are going from an inverted yield curve to a normal one.

2-year vs. 5-year: The spread might be relatively small, often ranging from 10 to 50 basis points (0.10% to 0.50%).

5-year vs. 10-year: The spread can be larger, ranging from 20 to 60 basis points (0.20% to 0.60%).

10-year vs. 20-year: The spread might range between 20 to 50 basis points (0.20% to 0.50%).

20-year vs. 30-year: The difference is often narrower since they're both long-term maturities. The spread might range from 10 to 30 basis points (0.10% to 0.30%).

These are estimates based on historical averages in the U.S. The actual spreads can be larger or smaller depending on the economy and the FED policy.

If the FFR stays around 5% in 2024, the long bonds (20 years and 30 years) can quickly move to about 6 % and more in a normal yield curve environment.

Scenario 1

The economy is moderately growing. Inflation is in the 3-handle range. This is the official FED forecast for most of 2024. FED Funds may be between 4 % and 5 %. Rates would be in restrictive territory with real yields of approximately. 1%.

Adding the substantial fiscal deficit, which will not go away any time soon (during war times, it may even increase considerably), continuous quantitative tightening by the FED (the FED will not buy those bonds), little demand from former bond buyers such as China, the Arab countries, etc., some selling from the BoJ to defend the Yen, weak demand from US banks, it becomes quite likely that the term premium demanded by bond buyers will not decline but rather increase during the next 1 - 2 years. Despite declining inflation, yields may stay "higher for longer," therefore.

Scenario 2

The economy is moderately growing. Inflation is in the 2-handle range. FED Funds may thus be between 3 % and 4 %. This is still in restrictive territory, - with real yields of appr. 1%. Inflation-wise, this is the official FED forecast for 2025, maybe starting in late 2024.

Development Stages

We will see two stages on the way to the normal yield curve regime.

Stage 1 – Yields move to a flat yield curve regime and stay there for a while. I expect this to be complete by late 2023 and remain unchanged until early 2024. This may coincide with a year-end rally in stocks that may start when the yield curve disinversion has stopped (going flat) a bit north of 5 %.

Stage 2 – Yields move on to the normal yield curve regime. I expect this development to start in the second quarter of 2024 gradually. This may coincide with a larger-scale correction/consolidation and some repricing of assets.

I will soon synch the yield predictions with the stock market predictions (Elliot Wave count) in a separate post.