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Analysis: Fearing Fed error, investors track less obvious parts of yield curve

By Davide Barbuscia

https://www.reuters.com/business/fearing-fed-error-investors-track-less-obvious-parts-yield-curve-2022-02-03/

NEW YORK, Feb 3 (Reuters) - Investors seeking to gauge the impact of the U.S. Federal Reserve's rate-hiking plans are keeping an eye on less closely watched corners of the U.S. Treasuries market that appear to have priced in the risk of a sharp economic slowdown.

The shape of the U.S. Treasuries yield curve reveals monetary policy and economic growth expectations, and curve inversions - which happen when shorter-dated debt yields more than government bonds with longer maturities - are seen as presaging recessions, particularly in the closely followed two-year and 10-year spread. read more

Analysts are pointing to inversions in lesser-followed sections of the curve: The yield premium of U.S. Treasury 10-year bonds over seven-year notes went negative in intraday trade last week for the first time since mid December, and forwards contracts saw an inversion.

"Whenever you see an inversion, it does raise concerns," said Edward Moya, senior market analyst at Oanda.

Technical factors may contribute to some of those inversions, but some investors still see them as reflecting broader concerns that the U.S. central bank may hurt the economy by hiking interest rates too aggressively to counter inflation.

"Markets are still a little bit nervous of the Fed overshooting," said John Herrmann, director of U.S. interest rates forecasts and strategy at NatWest Markets Securities.

"When I talk to clients, 90% of clients are in the camp that they're worried over the next two years to three years that the Fed does a policy mistake," he said, pointing to concerns that the Fed may have to resort to cutting rates after raising them, should its planned policy tightening damage the economic outlook.

Yields of shorter-dated U.S. government bonds have been rising at a much faster pace this year than longer paper, flattening the curve on expectations of an aggressive path of interest rate hikes.

"That sort of dynamic in the spot market is going to translate into much flatter forward curves in the forward market," said Subadra Rajappa, head of U.S. interest rate strategy at Societe Generale.

"So it's not something that's imminent ... but it's not something that you totally ignore either."

The yield curve steepened slightly this week after Fed officials spoke cautiously about the central bank's path after a widely expected March hike.

'RARE EVENT'

Investors typically look at inversions between two-year and 10-year notes as a classic sign that a recession may be coming in about one to two years. That part of the curve is not close to inversion, although it has been flattening sharply.

Other inversions, such as the one between three-month bills and 10-year notes , are also closely watched for their recession-presaging track record. That spread is also not close to inversion.

However, other parts of the curve have inverted.

The 7s/10s spread became negative briefly last week. The 20s/30s spread , in negative territory since late October, has widened to about -6 basis points from -3.30 bps on Dec. 31.

Those parts of the curve are influenced by supply and demand dynamics that make them less relevant for recession risk. For instance, pension and insurance companies looking to invest long-term tend to park their money in 30-year bonds more than 20-year ones, reducing the spread between those two maturities.

Additionally, in a flight-to-safety scenario such as when stocks tumble, investors would typically buy 10-year Treasuries, therefore reducing their premium over seven-year paper.

Still, "it's really hard to know how much of that is technical versus something fundamental," Rajappa said in reference to the brief inversion of the 7s/10s curve.

In the forwards market, which prices Treasuries for future deliveries, the two-year forward curve measuring the gap between two-year and 30-year Treasuries inverted on Monday, Citi analysts said in a note, calling it a "rare event".

Five-year and seven-year Treasuries yields were inverted in two- and three-year forward contracts on Monday, said Herrmann.

Credit Suisse said on Wednesday that a yield curve inversion this time around may not be the perfect predictor of a recession, given current economic conditions and the Fed's focus on reducing inflation. read more

Matthew Nest, global head of active fixed income at State Street Global Advisors, said he was focused on the 2s/10s and 5s/30s curves, rather than the forward market. The 5s/30s curve has also been flattening this year.

"Curve inversions generally lead recession by 12-18 months so if the curve inverts in two years time, it is likely three years before recession becomes a real threat," Nest said.

EXPLAINER-The U.S. yield curve has been flattening: Why you should care

CONTRIBUTORS
Davide Barbuscia Reuters
David Randall Reuters

PUBLISHED

FEB 3, 2022 1:00AM EST

https://www.nasdaq.com/articles/explainer-the-u.s.-yield-curve-has-been-flattening%3A-why-you-should-care

By Davide Barbuscia and David Randall

NEW YORK, Feb 3 (Reuters) - The U.S. Treasury yield curve has been flattening over the last few months as the Federal Reserve prepares to hike rates, and some analysts are forecasting more extreme moves or even inversion.

The shape of the yield curve is a key metric investors watch as it impacts other asset prices, feeds through to banks' returns and even predicts how the economy will fare. Here's a quick primer explaining what a steep, flat or inverted yield curve means and whether it will forecast the next U.S. recession.
WHAT IS THE U.S. TREASURY YIELD CURVE?

The U.S. Treasury finances federal government budget obligations by issuing various forms of debt. The $23 trillion Treasury market includes Treasury bills with maturities from one month out to one year, notes from two years to 10 years, as well as 20-and 30-year bonds.

The yield curve plots the yield of all Treasury securities.

WHAT SHOULD THE CURVE LOOK LIKE?

Typically, the curve slopes upwards because investors expect more compensation for taking on the risk that rising inflation will lower the expected return from owning longer-dated bonds. That means a 10-year note typically yields more than a 2-year note because it has a longer duration. Yields move inversely to prices.

A steepening curve typically signals expectations of stronger economic activity, higher inflation, and higher interest rates. A flattening curve can mean the opposite: investors expect rate hikes in the near term and have lost confidence in the economy's growth outlook.

WHY IS THE YIELD CURVE FLATTENING NOW?

Yields of short-term U.S. government debt have been rising fast this year reflecting expectations of a series of rate hikes by the U.S. Federal Reserve, while longer-dated government bond yields have moved at a slower pace amid concerns that policy tightening may hurt the economy.

As a result, the shape of the Treasury yield curve has been generally flattening. A closely watched part of the curve, measuring the spread between yields on two- and 10-year Treasury notes US2US10=RR, shows the gap at roughly 60 basis points, nearly 20 points lower than where it ended 2021. That flattening steadied this week as investors viewed some Fed officials as being a bit less hawkish.

While rate increases can be a weapon against inflation, they can also slow economic growth by increasing the cost of borrowing for everything from mortgages to car loans.

Two-year U.S. Treasury yields US2YT=RR, which track short-term interest-rate expectations, have risen to 1.16% from 0.73% at the end of last year - a 60% increase.

U.S. benchmark 10-year yields US10YT=RR have gone up to about 1.8% from 1.5%, a 20% rise.

WHAT DOES AN INVERTED CURVE MEAN, AND WILL IT HAPPEN?

Some investors and strategists are starting to forecast a curve inversion could happen as soon as this year - an ominous sign.

The U.S. curve has inverted before each recession since 1955, with a recession following between six and 24 months later, according to a 2018 report by researchers at the Federal Reserve Bank of San Francisco. It offered a false signal just once in that time.

The last time the yield curve inverted was in 2019. The following year the United States entered a recession - albeit one caused by the global pandemic.

Strategists at Standard Chartered bank forecast the curve to be completely flat by mid-year and potentially invert by year-end.

Larry Fink, the chief executive of BlackRock, the world's biggest asset manager, has also warned about a possible curve inversion.

DOES THE WHOLE CURVE INVERT OR PARTS OF IT?

Traders typically watch the shape of the curve determined by comparing two-year and 10-year Treasury notes US2US10=TWEB, because a yield curve inversion on that spread has anticipated previous recessions. That is currently flattening but not yet close to inversion.

But distortions can occur anywhere along the curve without inverting the entire curve.

On Friday, a less closely watched part of the curve inverted intraday US7US10=TWEB, with the premium of U.S. Treasury 10-year notes over seven-year Treasuries going briefly into negative territory.

The 20-year/30-year spread US20US30=TWEB has been negative since late October, though supply and demand technical factors may have contributed to that.

WHAT DOES THIS MEAN FOR THE REAL WORLD?

Aside from signals it may flash on the economy, the shape of the yield curve has ramifications for consumers and business.

When short-term rates increase, U.S. banks tend to raise their benchmark rates for a wide range of consumer and commercial loans, including small business loans and credit cards, making borrowing more expensive for consumers. Mortgage rates also rise.

When the yield curve steepens, banks are able to borrow money at lower interest rates and lend at higher interest rates. Conversely, when the curve is flatter they find their margins squeezed, which may deter lending.

(Reporting by Davide Barbuscia and David Randall; Editing by Megan Davies and Andrea Ricci)

((Davide.Barbuscia@thomsonreuters.com; +1 917 285 3067; Reuters Messaging: davide.barbuscia.reuters.com@reuters.net))

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