The bear steepener, the Dollar, and the Fed’s path
Considering its year-over-year (YoY) performance, the U.S. Treasury yield curve has been in a bear steepener, a market phase where both short- and long-term interest rates are rising, but long-term yields are increasing at a faster rate. This has caused the 30-year minus 2-year spread to widen to +122 basis points, a level not seen in roughly three years. This marks a sharp reversal from the deep inversion that characterized the market in 2022 and 2023, signaling a fundamental shift in market sentiment from recessionary fears to expectations of economic growth and persistent inflation.
The “bear” aspect signifies a negative development for bond prices, as investors demand a higher “term premium” to hold long-duration assets. Recently, this has been driven by expectations of sticky inflation, expectations of nominal growth fueled by public spending, higher term premium, the “AI Boom,” and a significant increase in Treasury supply. The current market signals align with historical parallels, such as in 1994–95 or 2021, when long-duration bonds underperformed while cyclical sectors like financials and value stocks thrived.
The movement of the yield curve is particularly critical given the U.S. dollar’s recent performance, which has already lost 9% of its value year-to-date. The ongoing bear steepener, which points to expectations of robust long-term growth and inflation, can be seen as a continuation of this trend. When the economy is perceived as strong, investors often move away from safe-haven assets like the dollar and into riskier, higher-yielding assets abroad. The bear steepener, with its higher long-term yields, also makes long-duration U.S. assets less appealing, which can further fuel a bearish sentiment toward the USD. The dollar’s future weakness, however, may depend on a crucial shift from the current bear steepener to a “bull steepener.” A bull steepener occurs when short-term yields fall faster than long-term yields, often triggered by Federal Reserve interest rate cuts in response to a weakening economy or imminent recession.
Ultimately, the current yield curve’s position near a three-year high sends a clear message. The market is not yet convinced that disinflation is on a smooth path, nor does it expect a rapid, aggressive pivot from the Federal Reserve. While July’s CPI showed a cooling in prices for certain tariff-exposed goods, a sign that the effects of these new levies are being absorbed, PPI figures and services inflation remained firm. This mixed economic picture, with goods prices easing but services and some key components staying hot, maintains the dilemma for the Fed and reinforces the view that an aggressive cutting cycle is not yet assured, even with an initial cut on the horizon. This setup is particularly relevant ahead of the release of the PCE report tomorrow, which is the Fed’s preferred measure of inflation. For the U.S. dollar, its 2025 weakness is deeply intertwined with the dynamic in the bond market, and its future trajectory will be a function of whether this steepening trend persists or if a weakening economy eventually forces a shift from bear to bull.
Eurozone fractures
Bearish forces – cited in Tuesday’s report – hindered EUR/USD’s ability to push north of 1.1660 (this week’s resistance), as they found fresh momentum yesterday: In addition to the ongoing French political turmoil, instability in the Netherlands has now entered the picture. Dutch Prime Minister Dick Schoof and his cabinet faced, yet ultimately survived, a no-confidence vote. The motion was filed by Stephan van Baarle, head of the DENK party, after a centre-right party quit the coalition over disagreements regarding tougher measures against Israel. Attention now shifts to campaigning for the October 29 snap elections. Despite the vote outcome, political divisions remain deep, with heated debates exposing rifts among the 15 parties in parliament. With the vote secured and no fresh developments from France, the euro found some reprieve later in the session, trimming earlier losses and closing flat.
Also, the European Union has decided to remove all tariffs on U.S. industrial goods by the end of the week, as requested by President Trump, in order to avoid a 27.5% tariff on car and auto parts exports to the U.S. It’s yet another Trump-esque move, with the EU conceding that the trade arrangement favours the U.S. – but arguing that it’s necessary to restore certainty.
The correlation between the euro and sovereign eurozone spreads is generally minimal, except for brief spikes during periods of intense bond market stress. That said, the widening of spreads reflects more than just credit risk; it includes factors such as liquidity premia, supply pressures, and overall market sentiment. In the current context, the EU’s concession – reviving concerns about the eurozone’s ability to negotiate favourable terms – combined with two governments teetering on the edge of collapse, suggests that spreads have room to widen further, likely pushing beyond the 80 basis point mark, and exerting more pronounced downward pressure on the euro. The downside risk is likely to be short-lived, as developments in the U.S. continue to be the primary driver of the euro.
We therefore believe EUR/USD may end the week in the 1.15 zone. Political turmoil is expected to persist into September, and a surprise upside in Friday’s PCE data may be the final catalyst for EUR/USD to dip south of 1.16.
Turning to EUR/CHF, the pair has historically shown a stronger correlation with eurozone sovereign spreads than EUR/USD. It continues to edge lower, down nearly 1% this week. Here, political instability across key eurozone countries is more acutely felt, given Switzerland’s close ties to the bloc. The pair may test 0.93 this week, erasing most of the gains from early August that followed the 39% tariff imposed on Swiss exports, which had weakened the franc.
With the U.S. dollar clouded by concerns over the Fed’s independence, the pound weighed down by debt sustainability issues, the yen facing rising stagflationary risks, and the euro suffering from sentiment-driven weakness, the franc’s haven status is once again being revived.
Yield differential helps the Loonie
The yield differential between two-year U.S. and Canadian government notes has been a dominant theme for the Canadian dollar over the past year. For the better part of the last 10 months, this spread has consistently held above 100 basis points (bps), providing a significant tailwind for the U.S. dollar and keeping the Loonie on its back foot. The recent narrowing of this spread to 90 bps is therefore a notable shift, marking the first break below this key threshold in almost a year. This has been a crucial factor in the CAD’s move lower this week, dropping it below the 1.38 level against the USD, and suggesting a potential change in the long-standing currency dynamic.
This recent narrowing comes against a backdrop of a bear steepening U.S. yield curve. Unlike the conventional view that a steeper curve signals a stronger economy, a bear steepening is often seen as a negative for the U.S. dollar as it reflects growing concerns over inflation, fiscal sustainability and a “higher-for-longer” rate environment that could eventually stifle economic growth. The recent narrowing of the short-term yield differential from historic highs has been the primary driver of the Loonie’s strength so far this week, and the market’s response to the upcoming U.S. PCE data will be key.
BoE Pivot risks GBP reversal
GBP/USD maintained its upward momentum until mid-August, when signs of fatigue began to emerge. The rally had been fueled by a hawkish repricing of Bank of England expectations, driven by stronger-than-anticipated macroeconomic data and stubbornly high inflation.
But bearish forces are just waiting around the corner. The BoE may pivot to a more dovish stance this autumn, while concerns over fiscal instability – exacerbated by adherence to a self-imposed fiscal rule – continue to weigh on sterling. On Tuesday, UK long-term bond yields surged to levels not seen in nearly three decades. The 30-year yield climbed to 5.63%.
This spike intensifies pressure on Prime Minister Keir Starmer’s government to tighten fiscal policy to soothe investor concerns. Yet, as demonstrated by the previous hike in employers’ national insurance contributions and its dampening effect on economic activity, further tightening could deepen downside risks for the pound.
Euro, Pound stall
Table: Currency trends, trading ranges and technical indicators
Key global risk events
Calendar: 25 – 31 August
All times are in ET
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*The FX rates published are provided by Convera’s Market Insights team for research purposes only. The rates have a unique source and may not align to any live exchange rates quoted on other sites. They are not an indication of actual buy/sell rates, or a financial offer.
