A New U.S. Yield Curve Is Racing Toward Inversion

(Bloomberg Opinion) -- The prospect of an inverted U.S. Treasury yield curve is back on bond traders’ radars. It’s just not the part they expected.

For most of this year, the yield spread between seven- and 10-year Treasuries was the smallest of all benchmark U.S. maturities, never closing above 10 basis points and dipping to as low as 2 basis points in mid-May. Some strategists predicted that the difference would eventually fall below zero and encourage other parts of the curve to invert. That never happened.

Since the U.S. stock market began its decline in early October, though, the shortest-dated Treasury notes are leading the way toward inversion. As of mid-November, the yield curve from two to five years is flatter than the one from seven to 10 years, a phenomenon that hasn’t happened since the 2013 taper tantrum. The yield difference between two- and five-year notes fell this week to 4.6 basis points, the smallest gap since September 2007. That month should ring a bell for any seasoned bond trader: It was when the Federal Reserve cut its benchmark lending rate by 50 basis points, its first of many reductions over the ensuing 15 months.

No one is seriously predicting that the Fed is on the verge of a rate cut, of course. But the talk of a “pause” in its gradual tightening cycle has reached a fever pitch, encouraged in no small part by a perceived change in tone from officials like Vice Chairman Richard Clarida. The theory is that with fluctuating equity prices, plunging inflation expectations and some weakening in economic data, policy makers will want to reserve the right to adjust the once-a-quarter pace of rate increases that has effectively been on autopilot since December 2016. The more extreme view is that the Fed will be “one-and-done,” lifting rates in December and then holding off for the foreseeable future.

It wouldn’t necessarily take much to get the spread between two- and five-year Treasuries to invert. Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets, says it could happen as soon as March if policy makers raise interest rates in December and then again three months later. The curve flattening “points to the idea that the Fed is running out of market sympathy for it’s normalization ambitions,” he said.

The yield spread is basically flashing the same signs as eurodollar futures and the fed funds market. But conceptually, it’s a bit easier to grasp. If an investor demands the same yield on a five-year Treasury note as one that matures in two years, they must be betting that interest rates will be little changed over those extra three years. If the curve inverts, it means that rates are seen as likely to fall. The gap between two- and five-year Treasuries was last below zero in mid-2007, three months before a rate cut and six months before the recession began.

Now, that curve flirted with inversion in the previous cycle as early as August 2005, and the Fed raised rates seven more times after that. So it’s not quite a foolproof gauge for when the central bank will back off its tightening path. Then again, given that what followed was the worst recession since the Great Depression, today’s policy makers might show more restraint. 

I wrote in September that with a handful of Treasury maturities yielding close to 3 percent, investors faced a duration dilemma. They face the same issue today in pricing short-term notes. The difference, though, is that unlike the benchmark 10-year rate, yields on two-, three- and five-year notes are highly dependent on Fed policy. Odds are that the market hasn’t divined the central bank’s precise path for the coming half-decade.  

Bond traders heard from Clarida on Tuesday, and it appeared to do little to change their outlook for slowing rate hikes. Fed Chairman Jerome Powell is set to speak on Wednesday to the Economic Club of New York, and then the central bank will release minutes of its November meeting on Thursday. Needless to say, the market is clamoring for some clarity by the week’s end.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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