Inversion Jitters Aside, One U.S. Curve Is Steepest Since 2017

(Bloomberg) -- Voracious demand for five-year Treasuries of late is driving the short- and long-ends of the U.S. yield curve in opposite directions as investors price in Federal Reserve interest-rate cuts.

The spread between 5- and 30-year Treasury yields widened to 68 basis points this week, the steepest level since 2017. That stands in sharp contrast to the gap between 2- and 5-year yields, which has been inverted for most of the past four months, as well as the difference between 3-month and 10-year rates, which flipped negative last week for the first time since 2007.

At the heart of the divergence is a growing appetite for what’s known as the “belly” of the curve. Traders are buying 5-year notes in a wager that the Fed will lower rates in response to a U.S. economic downturn, according to TD Securities (USA) LLC’s Priya Misra. That’s not her base case -- she finds the market too pessimistic about the growth outlook -- but she agrees that purchasing the belly makes sense for those who expect a recession.

“It’s a classic ‘recession-is-coming’ trade,” said Misra, head of global rates strategy. “It’s a safer place for investors to buy if they think that the Fed is about to cut over the next year or so.”

That demand can also be seen in the 2-, 5-, and 30-year fly. The spread narrowed to its tightest level since 2016 on Monday, illustrating outperformance in the five-year relative to short- and long-dated Treasuries.

Traders have repriced the Fed’s policy outlook following the central bank’s unexpected downgrade of its rate-hike projections last week. Overnight index swaps indicate around 5 basis points of cuts priced into the Fed’s June meeting, and a full quarter-point cut by the end of this year.

It makes “perfect sense” to see traders drive a wedge between the two curves, according to BMO Capital Markets strategist Jon Hill, given the time-frame of a possible Fed rate cut.

“It’s a pure path-of-policy story,” Hill said. “Rate cuts are coming, but they’re not imminent -- they’re more likely to be in that two- to five-year forward window than in the next two years.”

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