Bull Flattener

What Is a Bull Flattener?

A bull flattener is a yield-rate environment in which long-term rates are decreasing more quickly than short-term rates. That causes the yield curve to flatten as the short-run and long-run rates start to converge.

How a Bull Flattener Works

The yield curve is a graph that plots the yields of similar-quality bonds against their maturities, ranging from shortest to longest. Yield curves are typically constructed using U.S. Treasury securities. The yield curve shows the yields of bonds with maturities ranging from one month to 30 years. In a normal interest rate environment, the curve slopes upward from left to right. Bonds with short-term maturities usually have lower yields than bonds with long-term maturities because they have lower interest rate risk.

Different factors influence the short and long ends of the yield curve. The short end of the yield curve based on short-term interest rates is determined by expectations of the Federal Reserve policy concerning rates. The short end rises when the Fed is expected to raise rates and falls when investors anticipate interest rate cuts. The long end of the yield curve is influenced by factors such as the inflation outlook, investor demand, the federal budget deficit, and anticipated economic growth.

The yield curve can steepen or flatten. When the yield curve steepens, the spread between the short-term and long-term interest rates widens, making the curve appear steeper. A flattening yield curve, on the other hand, occurs when the spread between long-term and short-term interest rates on bonds decreases. A flattener can either be a bear flattener or a bull flattener.

In a bull flattener, long-term interest rates fall faster than short-term interest rates, making the yield curve flatter. When the yield curve flattens as a result of short-term interest rates rising more quickly than long-term interest rates, it is a bear flattener. This change in the yield curve often precedes the Fed raising short-term interest rates, which is bearish for both the economy and the stock market.

Advantages of a Bull Flattener

A bull flattener is seen as a bullish indicator for the economy. It could indicate that investors expect inflation to fall in the long term, leading to comparatively lower long-term rates. If the prediction of lower long-term inflation comes true, the Fed has more room to lower short-term interest rates. When the Fed lowers short-term rates, it is generally considered bullish for both the economy and the stock market. A bull flattener could also occur as more investors choose long-term bonds relative to short-term bonds, which drives long-term bond prices up and reduces yields.

A bull flattener is usually, but not always, followed by gains in the stock market and growth in the economy.

Disadvantages of a Bull Flattener

While a bull flattener is usually bullish for most of the economy in the short-term, the long-term effects are quite different. A bull flattener is often driven by falling interest rates, which directly increase bond prices and returns in the short run. However, higher bond prices mean lower yields and lower returns for bonds in the future. It is precisely those lower anticipated returns for bonds that drive investors into the stock market. That raises stock prices in the short term, but higher stock prices mean lower dividend yields and lower returns for stocks in the long run.

A bull flattener can even occur because expected long-term growth, rather than inflation, declined. However, that is rare because economic growth is much more stable and predictable than inflation.

Example of a Bull Flattener

When the yields on long-dated bonds fall more quickly than interest rates on short-term bonds, interest rates start to converge in a normal rate environment. The convergence, in turn, flattens the yield curve when plotted on a graph. Suppose that two-year Treasuries yield 2.07%, and ten-year Treasuries yield 2.85% on February 9. On March 10, two-year Treasuries yield 2.05%, while ten-year Treasuries yield 2.35%. The difference went from 78 basis points to 30 basis points, so the yield curve flattened. The flattening occurred because the long end, the ten-year Treasury, fell by 50 basis points compared to the decline of 2 basis points in the short end, the two-year Treasury. Long-term rates declined faster than short-term rates, so it was a bull flattener.