Goldman Sachs: Steeper Curves, Underlying Composition May Reflect Flow Imbalance

Goldman Sachs note that “neither a weaker-than-expected jobs report nor a marginally dovish FOMC was able to deter market repricing to higher yield levels, particularly at longer maturities. The 2s10s curve has steepened nearly 50bp from recent lows, though at least half of that move, which occurred in early April following equally sharp flattening in late March, had the characteristics of hedging flows. The steepening seen this week, in our mind, is harder to explain. While a dovish Fed alongside persistent inflationary pressures could translate to a steeper nominal curve, a look at the behaviour of the real and inflation components doesn’t appear to support this interpretation. Real yields are up between 20-30bp across the curve, even as breakevens have set lower across the curve, particularly at shorter maturities; the steepening of the inflation component was responsible for virtually all the steepening in the nominal curve. This price action is all the more intriguing, given that front end inflation swaps in Europe have held up over this time. One possible explanation is that the moves are technical in nature, the result of large outflows from TIPS funds. EPFR data suggest that this week saw the largest outflow since 2010 on an absolute basis, and the largest since March 2020 as a percent of AUM. To the extent these outflows are indicative of broader flows, the price action could make sense, given that there was greater interest in shorter maturity TIPS. If our hypothesis is correct, we would expect a reversal of these component-wise moves, though the move steeper in the overall nominal yield curve could persist in the near term. We therefore see risks that in addition to higher levels, U.S. yield curves will be steeper in the near term than our forecasts suggest, though we retain a flattening bias over the course of the cycle.”