The US government bond market's recession signal has weakened in recent days, yet robust economic data is adding to fears that the improvement will be short-lived.
The spread between 2-year and 10-year Treasury yields closed at 70 basis points (bps) on Aug. 3, as a push by the US government to increase borrowing in 2023 boosted longer-dated yields. The spread on this key portion of the yield curve grew to a more than 40-year high of 108 bps in early July, deepening the curve's inversion, which occurs when interest rates on shorter-term government debt are higher than on longer-term bonds.
The inversion has long been a predictor of recession, yet it comes as recent data shows an otherwise strong US economy. The persistence of near historic low unemployment and wage gains that are pressuring inflation is likely to force the US Federal Reserve to continue raising benchmark interest rates. This threatens to push closely linked short-term bond rates higher and deepen the more-than-yearlong inversion.
"The expectations for more rate hikes would bring along a bear flattening of the yield curve, and depending on how severely the additional rate hikes impact the economy, long-term yields might fall, deepening the inversion of the yield curve," said Althea Spinozzi, a senior fixed-income strategist at Saxo Bank.
Borrowing deluge
The Treasury Department announced Aug. 2 that it was selling $103 billion of longer-term securities as part of a quarterly sale, up from $96 billion in May, and said it plans to increase upcoming Treasury bill auction sizes.
"The Treasury is going to be sharply increasing issuance to fund rising deficits," said Kathy Jones, managing director and chief fixed-income strategist with the Schwab Center for Financial Research. "With the debt ceiling agreement in place, Treasury has to catch up on funding and is increasing issuance across the yield curve. The added supply is weighing on the market."
The 10-year bond yield increased by 45 bps from July 19 to Aug. 3, while the 2-year yield increased only 16 bps over that stretch.
Economy hums along
In addition to increased issuance, intermediate and long-term rates have risen on firmer-than-expected economic data and growing views that the Fed will likely keep rates higher for longer than initially anticipated and could even hike them more before the end of the year, Jones said.
"Not quite a perfect storm, but enough to shake up the market," Jones said.
Inflation expectations have come down since the Fed began hiking rates in March 2022. The 5-year break-even inflation rate, a measure of the bond market's outlook for inflation in 5 years, fell to 2.24% on Aug. 3, down 135 bps from March 2022.
Still, inflation levels remain well above the Fed's 2% target, leaving open the possibility of further interest rate increases. The personal consumption expenditures price index, excluding food and energy — the Fed's preferred inflation measure also known as core inflation — was at 4.1% in June, approximately double the Fed's goal.
"I think we've likely seen the most inverted curve levels of this cycle, but we have seen a number of times when the curve has re-steepened in this cycle only to continue moving back toward record levels of inversion," said Gennadiy Goldberg, a senior US rates strategist at TD Securities.
The 2-year and 10-year portion of the curve likely reached its most inverted of this cycle in early July. However, if inflation stays hot and the labor market fails to cool, those levels of deep inversion could be tested again, Goldberg said.
"In the near term, volatility is likely to persist as the market digests incoming data and the moves remain highly volatile," Goldberg said.
