Sorry I know this is pretty dense, but I think these two articles are worth a read. The FT article is much shorter so you can start with that one:
An alternative interpretation of a potential inversion is that bond markets are on board with the Fed’s strategy and believe that inflation will stabilise in the long term. A far more concerning prospect is a steep rise in long-term yields. This would indicate market belief that high rates will be needed for some time in order to achieve price stability. At the moment, movements in equity markets indicate that many investors remain bullish — the S&P 500 has shown no signs of sustained falls.
Either way, there is good reason to think that “this time is different”. The predictive powers of inversion have never been truly tested at a time of very large central bank holdings of long-term debt. The Fed not only has to make choices about the level at which to set its main short-term policy rate but also how to manage its own vast stock of Treasuries. At present, Powell is indicating the central bank will first raise short-term rates and only then start selling its longer-dated bonds. An inverted yield curve would make some sense if markets believe the Fed will see this policy through.
Inverted yield curves may have historically predicted recession, but what inversion has meant in the past does not preclude a different outcome now or in the future. In any case, as all good economists know, an exception is always needed to prove a rule.
Here's another more technical article from Reuters arguing that U.S. Treasury yield curve divergence sends mixed recession signals.
But the 2-year/10-year yield curve also has its technical issues, and not everyone is convinced it's telling the true story.
“Something like 2s/10s, or 5s/30s, will definitely tell you that we're a lot flatter than we've ever been at the start of a hiking cycle,” said Gennadiy Goldberg, senior rates strategist at TD Securities.“Part of that is just the sheer amount of Treasuries that the Fed bought during their COVID QE (quantitative easing) program.” Analysts said the Fed's QE the last two years has resulted in an undervalued U.S. 10-year yield and could explain away the disparity in the two yield curves.
Stan Shipley, fixed income strategist, at Evercore ISI in New York cited research which suggests the 10-year yield would be around 3.60% without that stimulus. When the Fed starts shrinking its balance sheet via quantitative tightening, Shipley said the 10-year yield will rise to fair value.
The U.S. 10-year yield was last at 2.475% after hitting a peak of 2.5% on Friday, the highest since May 2019.
“Without QE/balance sheet expansion, the 10-year and 2-year spread would be around 140 basis points, which is hardly threatening and consistent with the 10-year and 3-month spread,” Shipley said.
The Evercore analyst thinks the 10-year yield should approach fair value in the first half of 2024, or about 120 basis points higher than the current level.
The U.S. 2-year yield, on the other hand, is fairly priced and Shipley expects the 2s-10s curve to widen.
What does it mean for the U.S. economy?
“Some of the 2-10 shape is down to the fact this is a far more aggressively priced Fed cycle than usual, the notion of how quickly the Fed will move is very front-loaded,” said Timothy Graf, head of EMEA macro strategy, at State Street.
“I suspect we will get a growth slowdown but will it lead to recession? It may be next year's story. Households will want to see the fuel prices coming down but generally household balance sheets are in pretty good shape.”
Love to hear people with more experience with the bond market chime in on these takes!
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