Techong's Global Research: Types of Yield Curve Risk: Flattening and Steepening.

There are two types of yield curve risk: steepening and flattening. Steepener means the widening of yield curve. Conversely, a situation in which the yield curve is flat is called flattener.

A yield curve is a line that interest rates of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity. In general, bonds have a lower interest rate for short-term such as treasury bills and higher interest rates for long-term bonds.

When there is an expectation that the economy will improve in the future, a curve steepening will occur where short-term demand increases and long-term demand decreases. On the contrary, under the forecast that the economy will slow down, the spread in long-term yields and short-term interest rates narrows, leading to curve flattening. This is the reason curve flattening is regarded as a precursor to the economic downturn.

Curve steepening and flattening are divided into two categories, bull(cut policy rate) and bear(raise policy rate).

Bull steepening is a phenomenon in which short-term interest rates fall due to possible policy rate cuts, leading to a curve. For example, when Federal Reserve is likely to lower the interest rates, the expectation of bull market occurs hoping that the economy will recover, and the stock market will be bullish. (interest rate cuts -> low short-term interest rates -> more yield spread

Bear Steepening refers to widening of yield curve caused by rising of long-term interest rates. When the expectations for break-even inflation rises, Federal Reserve tends to hike its policy rates to slow the price from skyrocketing. Investors will sell their fixed-rate long term bond to seek more attractive assets which offer higher interest rates. This will result to bear steepener since investors will likely pursue shorter maturity bonds. (inflation expectation -> interest rate increase -> investor sell long term and buy short-term bonds -> more yield spread)

Bull flattening refers to a flattening curve due to a fall in long-term interest rates. It happens when the inflation rate expectation is low so that investors find more safe-haven assets. For example, Japan had experience of deflation and investors have been purchasing bonds even though they offer low interest. (Low inflation rate -> investors buy assets that are higher than inflation rate)

Bear flattening refers to a flattening curve due to a higher short-term interest rate. The yield curve is to flatten as short-term rates start to ratchet higher in anticipation of the Federal Reserve embarking on a tightening monetary policy.