Why the yield curve may invert even if the Fed sees inflation pick up

The so-called yield curve has steadily flattened amid higher interest-rate expectations and a backdrop of lackluster inflation, unsettling market participants who feel the Treasurys market is only a few steps away from an even more ominous development: An inverted curve, widely considered a precursor to a recession.

The yield curve is a line plotting the yields across Treasury maturities from the shortest dated to the longest, and can reflect investor expectations for growth and inflation. A flatter curve is seen as a sign investors are worried about growth, while a so-called inversion, where short-term rates carry a higher yield premium than their longer-dated peers, has preceded nine recessions since 1955.

However, some argue the curve’s flattening will gain steam even if inflation normalizes closer to the Fed’s 2% annual target, considered healthy by the central bank. Analysts at BMO Capital Markets say price pressures could, in fact, hasten the move toward an inverted curve.

Higher inflation would accompany “higher terminal rate estimates … [and] eventually result in a flatter curve over time,” said Ian Lyngen and Aaron Kohli, interest-rate strategists at BMO Capital Markets.

A higher terminal rate would encourage the central bank to keep hiking rates and reducing its balance sheet. The terminal rate represents the “Goldilocks” interest rate that would neither boost or slow economic activity and is seen as the point where a central bank’s rate-hike cycle has ended.

The analysts said the twin-prongs of policy normalization, higher rates and a shrinking balance sheet, would push short-dated yields higher. They estimated the fed-funds rate, its benchmark interest rate and a close proxy of the two-year note yield, above 2% as early as the second-quarter of next year

Read: Should investors still worry if the yield curve sends this ominous signal?

Also read: Here’s why investors look too complacent about the Powell Fed

Therefore, the spread between the two-year yield TMUBMUSD02Y, +0.01%  and the 10-year yield TMUBMUSD10Y, -1.26% , a widely watched measure of the curve’s width, might only be three rate increases, a quarter-percentage point each, away from inverting. The yield spread between the two maturities has fallen to 0.69 percentage points as of Tuesday, the tightest gap since November 2007, from its postelection span of 1.34 percentage points (see chart below).

The spread between the 2-year Treasury yield and the 10-year Treasury yield has steadily narrowed

And with the central bank already raising rates in the face of tepid inflation readings, a pickup in inflation numbers may encourage current Fed. Gov. Jerome Powell, set to succeed Fed Chairwoman Janet Yellen, to press on with further monetary tightening, the strategists said.

“Confidence that the Fed will swiftly respond to the threat of inflation risks exaggerating the curve’s flattening bias,” said Ian Lyngen and Aaron Kohli, interest-rate strategists at BMO.

That is because slack in the labor market remains near the tightest levels in years. The so-called U-6 unemployment rate, the broadest gauge of joblessness, which also includes workers who are working part time, has fallen to 7.90% in October, notching a decade low.

The Fed’s adherence to the Phillips curve, an economic theory linking high inflation to low unemployment, has put the central bank under self-imposed pressure to tighten monetary policy.

In previous speeches, Yellen has articulated that the central bank should raise its fed-funds rate to prevent labor market tightness from causing inflation to overshoot its target. Otherwise, the Fed would be forced into an unenviable position of having to hike rates in an abrupt manner to temper price increases. i

Also check out: Yellen says Fed should be ‘wary’ of raising rates ‘too gradually’

While on the longer end of the yield curve, market participants said yields for extended maturity Treasurys are likely to stay anchored for the next few months. The search for income has depressed the long end of the curve, which offers higher yields than the short end, said Tom di Galoma, managing director of Treasurys trading at Seaport Global Securities.

There are “a variety of [investors] that have decided that they need yield, and they will continue to look for yield at the long-end market, and not the short-end market.”

With the central bank cranking rates higher, an investment in short-dated Treasurys will incur losses and prompt investors to pile onto long-dated bonds to escape the reaches of a normalizing Fed, he said.

All this may place a spotlight on October’s consumer price index report as stronger inflation numbers should in theory spark a selloff in long-dated Treasurys, boosting their yields, while applying the brakes to the curve’s flattening move.

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