Curvaceous Concerns

The yield on the 10-year U.S. Treasury note ticked up 0.06 percentage point today, to settle back above 2%. That's its highest yield in close to a month, and is about 0.48 percentage point higher than a year ago.

On the shorter end of the Treasury yield curve, the two-year U.S. Treasury note yield hit 1.72% today, its highest since late 2019 and up almost 1.6 percentage points in a year.

That puts the spread between the 10-year yield and the two-year yield at just 0.29. It's near the smallest difference since March 2020, during the early innings of the Covid-19 pandemic. Futures pricing has the 2/10 spread going negative early next year, as short-term yields increase more than long term ones. 

When that happens, it's known as an inversion of the U.S. Treasury yield curve—the slope plotting interest rates on Treasuries of different maturities. Generally, the opposite alignment is true, as inflation and default risk over a longer period tends to be greater than in the shorter term.

And when investors demand higher interest to lend for two years than for 10 years—as they soon might be—many see it as a sign of an impending recession. It implies that the economy won't be strong enough to push interest rates appreciably higher over the longer term.

History shows that not every yield curve inversion is immediately followed by a recession. But there hasn't been a recession in the U.S. over the past century that hasn't been preceded by an inversion of the yield curve.

The flattening of the curve has contributed to the concerns about the U.S. economic outlook lately, while adding to the "risk-off" sentiment in markets.

A lot can and will happen between now and a potential 2023 recession, and it's too early to tell whether the gloomiest predictions will materialize. But one thing that's for sure is that the surge in commodities prices as a result of the Ukraine-Russia war has pushed back by at least a few months the peak in monthly inflation readings.

That means the Federal Reserve may have to increase rates more aggressively than if the pace of inflation was moderating on its own, as many economists had predicted would be the case by this summer. The fear is that, in order to get inflation under control, the central bank might have to raise rates so quickly that it tips the economy into a recession.

The market's expectation of Fed policy this year has been all over the map. Currently, futures pricing implies seven quarter-point interest rate hikes this year, according to data from CME Group. That number first dropped when Russia invaded Ukraine two weeks ago, and has rebounded since.

The market's uncertainty is likely shared by many Fed officials as well, but the greater risk appears to be toward tighter policy. Here's Tim Duy, chief U.S. economist at SGH Macro Advisors, writing to clients today:

I don’t envy the Fed right now. It got sidetracked last year by following the conventional wisdom on inflation. [Chairman Jerome] Powell is correct that the Fed was certainly not alone on that issue. It wasn’t easy to correct that error before Ukraine, and even less easy now given that there is a greater risk that even higher headline inflation feeds through to core relative to recent energy shocks. Neither the data nor fortune has favored the Fed, and assuming inflation continues to run high, the Fed will shift to an even more hawkish stance.

Fed interest-rate policy is expressed through changes in the federal-funds rate, which banks use to lend to each other. It's an overnight rate and influences short-term yields more than long-term ones. That has contributed to the rise in the two-year Treasury of late. But with the concerns over long-term growth, a proportionate rise hasn't been felt in the 10-year.

It's the kind of scenario during which some could argue for the Fed to ease off of tightening policy as quickly. The monthly inflation readings aren't letting them do that.