Why Steep Yield Curves Aren't Always Good

• Japan's longer-term yields have risen sharply due to inflation and debt sustainability concerns, with gross debt at 230% of GDP (1.2 quadrillion yen), making this a 'bad steepening' scenario
• Rising Japanese yields threaten the global carry trade as borrowing costs increase, potentially triggering unwinding of positions that could hurt asset prices worldwide
• When yields rise due to inflation or debt fears rather than growth expectations, bonds lose their portfolio stabilization properties, requiring investors to diversify defense with cash, commodities, or alternative strategies

Summary

Key Topic: The relationship between yield curve steepening and market implications, with focus on when steep curves signal trouble rather than economic health.

Main Concepts:

The yield curve traditionally has a positive slope (10-year yields exceeding 2-year yields). While inversions have historically predicted recessions with 7 out of 8 accuracy over 50 years, including one false signal in 2023, steepening curves don't always indicate positive conditions.

Japan Case Study:

Japan's longer-term yields have risen significantly in recent weeks, driven by inflation concerns and debt sustainability fears rather than improved economic outlook. The country faces critical challenges with debt at 1.2 quadrillion yen (approximately 230% debt-to-GDP ratio). Japan remains an outlier among central banks, raising rates to combat inflation while others cut.

Market Implications:

Rising Japanese yields threaten the popular carry trade strategy (borrowing at low yields to invest elsewhere), potentially causing unwinding of positions that could hurt global asset prices. A weaker yen has partially offset this risk.

Portfolio Strategy:

When yields rise due to inflation or debt sustainability concerns rather than growth expectations, bonds fail as portfolio diversifiers. Equity-bond correlations have remained elevated in recent years, diminishing bonds' traditional defensive role.

Outlook:

Author Craig Basinger (Purpose Investments) expects inflation and debt sustainability risks to continue, requiring alternative defensive strategies including cash, commodities, or different diversification approaches beyond traditional bonds, though bonds remain important for economic slowdown protection.