Bond Traders Turn Eyes to What May Happen After Curve Inversion

(Bloomberg) -- The surprising move by Federal Reserve officials to slash the prospects of an interest-rate hike this year has one of the Treasury market’s favorite indicators edging closer to signaling recession. And that means some traders are already eyeing the next move in the opposite direction.

With the U.S. 10-year yield dipping below 2.50 percent, the gap between the 3-month and 10-year Treasury yields on Thursday shrank to its narrowest point since 2007. The Fed’s revised outlook was a dead weight on that curve, pushing it from more than 15 basis points early on Wednesday to within four basis points of zero. An inverted curve is widely considered to be an accurate predictor of an economic slump, and BMO Capital Markets is among those forecasting that the measure is likely to drop below zero.

Yet while inversion risks are prominent on many analysts’ radars, these conditions are also sharpening the focus on the next big wave that some traders are chasing. That’s the one that could see front-end rates drop sharply lower and the curve again becoming steeper. Such a move may be prompted by the first signs that Fed is losing faith in the economic outlook and that officials will need to resume rate cuts.

The market is “approaching a period where the thematic bull-steepening of the curve will begin, and timing that moment will be one of the most important decisions investors face in 2019,” said Jon Hill, a rates strategist at BMO.

Indeed, steepening is already being seen at some points further out on the curve and the central bank’s latest signals did have something to offer some early adopters of the steepening trade, thanks to heavy buying in the belly. Bets on an impending easing cycle on Wednesday drove the 5-year yield lower versus the 30-year rate, pushing that differential to its widest level since November 2017.

To contact the reporter on this story: Emily Barrett in New York at ebarrett25@bloomberg.net

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, Greg Chang

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