Understanding yield curve shifts: flattening and steepening explained

The bond yield curve serves as a key gauge for how markets are assessing the economic landscape. Rather than focusing solely on whether Treasury yields are moving up or down, traders pay close attention to how yields behave across various maturities. The gap between short-term and long-term yields offers insights into market expectations regarding inflation, economic expansion, and the trajectory of central bank policy.

This is where concepts like bear flattening, bull flattening, bear steepening, and bull steepening become relevant. While the jargon might seem complex, it becomes fairly simple once you break it down into two key questions:

• Are bond prices moving up or down?
• Is the curve getting flatter or steeper?

"Bear" signals that bond prices are declining, which shows up as rising bond yields, whereas "bull" indicates that bond prices are climbing, reflected in lower yields. "Flattening" refers to a narrowing gap between long-term and short-term yields, while "steepening" describes a widening of that difference.

The basics

The yield curve maps government bond yields across different maturities, ranging from short-dated bills to longer-term notes. A widely followed metric is the spread between 10-year and 2-year Treasury yields.

Consider this example:

• 2-year yield: 4.00%
• 10-year yield: 4.50%
• 10s2s spread: +50 basis points

If the 2-year climbs to 4.30% while the 10-year moves to 4.60%, the spread narrows from 50 to 30 basis points, which constitutes a flattening. Conversely, if the 2-year drops to 3.70% and the 10-year falls to 4.30%, the spread widens from 50 to 60 basis points, representing a steepening. The crucial point is that the curve's shape can shift even when both yields are moving in unison.

Bear Flattening

A bear flattening happens when bond prices drop, pushing yields higher, but the rise in short-term yields outpaces that of long-term yields.

For instance:

• 2-year: 4.00% → 4.50%
• 10-year: 4.50% → 4.70%

Both yields moved up, marking a bearish phase for the bond market. However, the 2-year yield increased more sharply, leading to a flatter curve. Bear flattening is frequently linked to expectations of tighter monetary policy. When markets anticipate that the central bank will hike rates or keep them elevated for an extended period, short-dated bonds can experience significant selling pressure since their yields are tightly tied to policy rate expectations.

Long-term yields may also rise, but if investors think that tighter policy will eventually slow growth and curb inflation, those increases might be more muted compared with the front end.

A notable bear flattening occurred in 2022 when the Federal Reserve aggressively hiked rates to combat inflation. Short-end yields surged much faster than their long-end counterparts, which were already pricing in potential economic slowdown from the tightening cycle.

Bull Flattening

A bull flattening occurs when bond prices increase and yields decline, but the fall in long-term yields is more pronounced than in short-term yields.

Here's an example:

• 2-year: 4.00% → 3.80%
• 10-year: 4.50% → 4.00%

Both yields drop, yet the steeper decline at the 10-year end flattens the curve. This scenario often emerges when investors grow more cautious about long-term growth prospects or when long-term inflation expectations ease. It can also happen when there's a flight to the safety of longer-duration government bonds.

A bull flattening doesn't necessarily indicate a more dovish central bank. The front end might stay relatively stable due to held-up policy rate expectations, while the long end falls as investors worry more about the economic outlook further down the road.

We saw a bull flattening in 2016 when rates were pinned at 0% alongside weak growth. Long-end yields dropped more than short rates, which were already at zero.

Bear Steepening

A bear steepening arises when bond prices fall and yields rise, but long-term yields increase more than short-term ones.

For example:

• 2-year: 4.00% → 4.20%
• 10-year: 4.50% → 5.00%

Both yields rise, but the 10-year yield climbs further, causing the curve to steepen. This pattern is often tied to concerns about higher long-term inflation, growth, or fiscal risks. The central bank might not be expected to lift short-term rates significantly, but investors demand greater compensation for holding longer-dated bonds.

The key distinction is that the driving force often comes from the longer end of the curve, rather than a sharp repricing of near-term policy moves. Bear steepening can therefore arise from worries about longer-term inflation or fiscal sustainability. Stronger growth expectations can also lead markets to price in higher long-term risk premiums.

We experienced a significant bear steepening in 2024 driven by firmer growth expectations and elevated inflation risks, linked to Fed rate cut expectations, AI investment, and rising odds of a Trump victory. long-end yields rose at a faster pace than short-end ones.

Bull Steepening

A bull steepening occurs when bond prices rise and yields fall, but short-term yields drop more than long-term yields.

Consider this scenario:

• 2-year: 4.00% → 3.30%
• 10-year: 4.50% → 4.20%

While both yields decline, the front end's more significant fall leads to a steeper curve. This move is often associated with expectations of central bank rate cuts. The long end might also decline, but potentially to a lesser extent because it embeds more than just the expected policy rate.

Bull steepening is often seen as a sign of a shift toward easier monetary policy. However, the underlying reason matters. A bull steepener driven by expectations of a smooth rate normalization differs from one sparked by a sudden recession shock. In the latter case, markets might aggressively price in central bank easing, causing short-term yields to plummet faster than long-term ones.

We saw a major bull steepening in 2020 due to the COVID shock and aggressive Fed easing. Front-end yields fell sharply toward zero.

Why the Shape Matters for Markets

The yield curve matters because various segments respond to different influences. The front end is heavily swayed by central bank policy expectations, while the long end is shaped by a mix of inflation and growth outlooks, fiscal policy, term premium, and expected future short-term rates.

This means that a headline like "Treasury yields rose" can carry vastly different implications. For instance, suppose there's a hawkish repricing by the Fed. The 2-year yield jumps 20 bps while the 10-year rises just 5 bps, resulting in a bear flattening. Here, the market is mainly adjusting expectations for the monetary policy path. On the flip side, if markets start anticipating stronger growth, the 2-year might rise 5 bps while the 10-year climbs 20 bps, producing a bear steepening. In that case, the market is assigning more risk to longer-term inflation, given the growth outlook.

It's worth remembering that a yield curve shift is a market signal, not a surefire economic prediction. The same curve movement can be interpreted differently depending on the broader context. So, context is crucial.