By Gertrude Chavez-Dreyfuss
NEW YORK (Reuters) – Two measures of the U.S. Treasury yield curve that are widely watched for recession warnings have veered in opposite directions, raising questions about the extent to which central bank bond purchases and other technical factors can distort signals about the path of the economy.
The spread between the yield on 3-month and 10-year treasuries this month has widened, which may be an indicator of economic expansion. On Friday, this curve reached its steepest slope in more than five years at 196 basis points.
The US 2-10 year curve, on the other hand, has flattened considerably this year and is about to reverse, where the longer maturity would yield less than the shorter.
Chart: US Yield Curves: https://fingfx.thomsonreuters.com/gfx/mkt/lbvgnmbnkpq/US%20yield%20curves.PNG
Typically, yield curves slope upward when investors demand a higher yield on long-term debt because it carries higher risk due to the higher probability of inflation or default.
A steepening curve generally signals expectations of stronger economic activity, higher inflation and higher interest rates. A flattening curve suggests investors have lost confidence in the economy’s growth prospects.
Reversals are seen as a harbinger of a possible recession. But the signal at this time is not clear.
“There is a technical issue here,” said Ben Emons, managing director of global macro strategy at Medley Global Advisors. “The yield on 3-month Treasury bills is still lower…because it doesn’t reflect future rate hikes. But it will rise, as the Fed raises rates.”
U.S. two-year yields, on the other hand, are a very good indicator of the direction of Federal Reserve policy over the next two years, Emons added, and they show a much steeper rate hike path.
The 2s/10s spread was last at 20.10bps, having compressed to 11.4bps on Monday, its tightest since March 9, 2020, before the coronavirus pandemic began.
The Fed raised short-term interest rates by 0.25 percentage points last week, the first hike since the end of 2018. U.S. rate futures on Friday priced a probability of around 75% tightening by half a percentage point at its monetary policy meeting in May. For 2022, the futures market expects about 200 basis points of cumulative Fed hikes.
“If policy unfolds as the market expects, the 3-month/10-year curve will start to flatten as more rate hikes are priced into the 3-month duration,” Dan Belton said. , Fixed Income Strategist at BMO Capital.
“The divergence in 3-month and 2-year Treasury rates suggests the market is pricing in an increasingly hawkish Fed over the next two years.”
The last time the 3-month/10-year curve inverted was in February 2020. A month later, the Fed cut the benchmark overnight lending rate to near zero as the pandemic coronavirus was wreaking economic havoc around the world.
2s-10s reversals, on the other hand, preceded the last eight recessions, including 10 of the last 13, according to BoFA Securities in a research note. The last time this curve inverted was in 2019. The following year, the United States entered a recession, albeit caused by the global pandemic.
Chart: US Yield Curves / Fed Tightening: https://fingfx.thomsonreuters.com/gfx/ce/akvezjmzwpr/Pasted%20image%201648228471373.png
THE US 2s/10s CURVE ALSO HAS QUESTIONS
But the 2-year/10-year yield curve also has its technical problems, and not everyone is convinced that it tells the truth.
“Something like 2s/10s, or 5s/30s, will definitely tell you that we are much flatter than ever at the start of an up cycle,” said Gennadiy Goldberg, senior rates strategist at TD Securities.
“Part of that is just the amount of Treasuries the Fed bought during its COVID QE (quantitative easing) program.” Analysts said the Fed’s QE over the past two years has led to an undervaluation of the US 10-year yield and could explain the disparity in the two yield curves.
Stan Shipley, fixed income strategist at Evercore ISI in New York, cited research that suggests the 10-year yield would be around 3.60% without this stimulus. When the Fed starts shrinking its balance sheet via quantitative tightening, Shipley said the 10-year yield will hit its fair value.
The US 10-year yield was last at 2.475% after hitting a high of 2.5% on Friday, the highest since May 2019.
“Without QE/balance sheet expansion, the 10yr and 2yr spread would be around 140bps, which is hardly threatening and consistent with the 10yr and 3m spread,” Shipley said. .
The Evercore analyst believes the 10-year yield should approach fair value in the first half of 2024, around 120 basis points higher than the current level.
The US 2-year yield, on the other hand, is reasonably priced and Shipley expects the 2s-10s curve to widen.
What does this mean for the US economy?
“Part of the 2-10 shape is because this is a much more aggressively priced Fed cycle than usual, the notion of how quickly the Fed will act is very overriding” , said Timothy Graf, head of macro strategy EMEA. , at State Street.
“I suspect we will have slower growth, but will that lead to recession? That could be next year’s story. Households will want to see fuel prices come down, but household balance sheets are generally in fairly good condition.”
(Reporting by Gertrude Chavez-Dreyfuss; Additional reporting by Sujata Rao-Coverley in London; Editing by Alden Bentley and Andrea Ricci)
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