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The shape of the yield curve is wreaking havoc for total return bond investors Cedars Hill Group — September 22, 2025 — Issue 200! Thanks for investing your time in reading these musings on life and the markets for 200 issues. It is my sincerest hope that you have earned a good return on that investment. Cedars Hill Group — September 22, 2025 -- Issue 200! Thanks for investing your time in reading these musings on life and the markets for 200 issues. It is my sincerest hope that you have earned a good return on that investment. After the Fed's 25bps cut last week this is how the yield curve changed week-over-week:  Yields increased from 5-years and out on the curve while short rates were mostly unchanged. Yields rose more for longer duration bonds which meant the worst performer on a risk-adjusted basis was the 30-year. The Fed meeting was negative for duration risk because the Fed didn’t cut 50bps and the market had priced in some probability that they would. We've been looking at the relationship between duration and crude oil due to the stagflation risk premium that had been priced into the market since Liberation Day. Since we first noticed this in early June the pressure on the Fed to lower rates has ramped up and the market has taken to pricing in lower rates while crude has continued to languish at the bottom of its recent trading range.   When we first started talking about the stagflation risk premium the dollar had been in a strong downward trend but since that time has come into a trading range as the administration has struck numerous trade deals and the focus has turned from trade policy to the longer-run impacts of those policy changes. During this time the negative correlation dynamic between crude in bonds remained in place despite the equity markets moving higher.   One would think that as the equity market moved higher growth prospects were increasing and that crude oil would be supported, especially with the dollar down significantly, however the push higher in equity prices seems to have been due to the expectations for lower interest rates which would support financial assets but not necessarily physical assets. Gold's breakout to new all-time highs adds an element of "demonetization" to this picture. It's probably safe to assume that the dollar would be lower than it is absent the increased imports we saw in April and May due to front-running of tariffs. Lower interest rates will certainly pull the dollar lower, and a lower dollar and interest rates are, at some point, supportive of domestic growth and commodities. We just haven't reached that point yet. Paradoxically, it will likely require much weaker growth to get to that point which will not be supportive of equities. The underperformance of commodities and crude specifically has created this situation where they might rally at the onset of a recession as they price in the recovery while equities have yet to price in the recession. Therefore, we have these two important correlation dynamics (commodities-rates and equity-rates) that we need to pay attention to when constructing our portfolios. This is critical because you have risky assets tied to growth such as equities and commodities that behave differently in different growth regimes providing distinct bets on different growth vectors. The 60/40 portfolio implicitly assumes a single correlation between the risky asset and the risk-free asset, but as we have already shown reality is far more nuanced than that. Just like there are many different stocks there are many kinds of bonds, each with different characteristics that will influence how they behave and their total return. We decompose fixed income risk into five factors: duration, yield curve, liquidity, credit, and optionality. When looking to diversify risky asset exposure with bonds you should primarily focus on duration and yield curve. Last week, we showed you a way to look at the total return implied by forward rates for each point on the yield curve. The forward returns for the belly are the lowest because investors have bid up the belly of the curve as they have priced in the Fed cutting rates to approximately 3%. However, if the forward rates aren't realized then the total returns will be different, so we looked at what the forwards were pricing in terms of yield changes and found that despite the belly having rallied the most the forward rates implied the biggest jump in yields. This reveals a complex dynamic within the bond market and requires a knowledge of basic bond math to decipher the message the market is telling us. It is easy to look at the curve today and see that it continues to have this U-shape and assume that the market is overpricing rate cuts and that either short rates or long rates are the best place to be, but we've seen a small change in the steepness on the back of the "U" that has a large impact on the belly. Essentially the market is pricing in more inflation through a steeper curve from the 3-year to the 30-year than it was a year ago. The trough in the yield curve is slightly higher but the market is also expecting a sharper rise in yields once they bottom.  If we get that sharp deceleration in growth that would be negative for equities it is likely we'd see the market take out this steepening in the belly which would see it outperform. When we look at our equity and commodity risk in our portfolio and see this vulnerability to a sharp deceleration in growth this is how we identify a need to add some duration risk.
But once we've identified the need we need to decide what point on the curve to buy and now that has been reduced to the belly or the long end. We ruled out the long end because to get a bull flattener we would need to see deflationary growth or some sort of financial crisis that drives a bull flattener. The yield curve has just come out of one of the longest periods of inversion in history and we have seen a secular shift in inflation and the overall direction of interest rates so the hurdle to buy long bond duration is very high. The curve would need to be much, much steeper to start paying investors for taking on those risks. General knowledge about factors in the equity market is much better than factors in the bond market because bonds have been an afterthought in most investors' portfolio for a long time but as monetary policy becomes increasingly politicized as the institutional crisis wears on and we continue into a secular bond bear market all the different dimensions within the bond market will become increasingly important for bond investors. Comments are closed.
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