Treasury curve is un-inverting for reasons that have little to do with recession
One of the bond market’s most widely followed gauges of impending U.S. recessions finished at its least-negative level in two months on Friday, after December’s producer prices data buttressed expectations for a continued drop in inflation.
The 2-year yield BX:TMUBMUSD02Y fell 12.2 basis points to 4.136% in New York trading, leaving it 18.7 basis points above the benchmark 10-year rate BX:TMUBMUSD10Y, which ended at 3.949%.
Ordinarily, the 10-year yield should be trading higher than its 2-year counterpart, creating an upward sloping Treasury yield curve. When it doesn’t, that means the curve is inverted, with the spread between the two rates below zero. On Friday, the 2y/10y spread finished at roughly where it was earlier in the day: its least-negative level since Nov. 1.
One of the bond market’s most reliable indicators of recession is turning less and less negative.
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Theoretically, the 2y/10y spread tends to go less negative as a U.S. recession approaches because of the bond market’s expectations for the Federal Reserve to start cutting interest rates. This time around, however, the un-inverting curve and rate-cut expectations have less to do with the prospects for economic growth and more to do with disinflation, according to Lawrence Gillum, the Charlotte, North Carolina-based chief fixed-income strategist for broker-dealer for LPL Financial.
“It’s more about the immaculate disinflation story that continues to play out and inflation getting back to 2% quicker than expected,” Gillum said via phone on Friday. “The narrative that disinversion means recession because the Fed is going to start cutting rates is not what’s playing out. The idea is that the Fed is going to start cutting, regardless of a recession, as inflation comes down.”
The disinversion of the Treasury curve played out on Friday despite events in the Middle East, which caused oil prices to settle at a one-week high and have the potential to rekindle inflation. Treasury yields mostly fell as the result of bull-steepening trades, in which the shorter-term part of the market rallied more than in the longer-term end. This is what drove the 2-year yield down by a greater magnitude than the 10-year yield on Friday.
The 2y/10y spread started falling into triple-digit negative territory during the first half of 2023 amid growing fears about the fallout from the Fed’s interest rate-hike campaign.
Right now, one sign that the market isn’t currently expecting a U.S. recession can be found in fed funds trading, according to Gillum. Traders would be expecting “a lot more” than 150 basis points of rate cuts, or six quarter-point moves, by year-end if they sensed an approaching economic downturn, the strategist said. As of Friday, fed funds futures traders saw a 29.3% chance of six quarter-point cuts by December and a 38.8% likelihood of seven reductions.
