A little more than two years after inverting, a key spread in the Treasury yield curve has returned to positive territory with the Federal Reserve ready to start cutting interest rates later this month.
The benchmark 10-year Treasury yield, which moves opposite to the bond's price, traded slightly above the two-year yield early Sept. 4, a return to the spread's typical pattern and a stark difference from a year ago, when it was trading about 70 basis points above the 10-year. In early July 2023, the two-year Treasury settled at a peak 108 basis points above the 10-year bond. The 2-year yield, which most closely reflects the government bond market's near-term expectations for the Fed's benchmark federal funds rate, has plunged about 126 basis points since its late April peak as the market expects the Fed to slash interest rates.
The inversion between these yields and the overall inverted yield curve, where investors receive higher yields for shorter duration bonds, is now nearing its end, with the curve steepening and few signs of a coming recession.
"Steepening will continue as the Fed has signaled it will be cutting rates and the economy doesn't appear headed for a deep recession," said Patrick Leary, managing director with Loop Capital Markets.
The 10-year yield could climb 50-to-75 basis points above the two-year as the market anticipates three rate cuts, each of 25 basis points, before the end of this year, and three or four more in 2025, Leary said.
"There is plenty of room for the Fed to cut rates from here which can pull the two-year treasury yield closer to 3% while 10-year treasuries are already in fair value range," said Kathy Jones, managing director and chief fixed-income strategist with the Schwab Center for Financial Research.
Where the yield curve goes from here largely depends on the path of the economy and how Fed monetary policy reacts. If the labor market surprisingly strengthens or inflation sees more acceleration, the Fed may keep its benchmark rate at more than 20-year highs, pushing two-year yields back up and keeping the curve inverted. Any pause in the cutting regime stands to steepen the curve as well.
However, if the economy appears headed for a recession, the Fed could cut rates more aggressively, causing the 10-year and two-year spread to surge beyond 100 basis points, said Joe Kalish, chief global macro strategist at Ned Davis Research.
Investors and market watchers expect the Fed to announce a rate cut of at least 25 basis points after its Sept. 17–18 meeting. As cuts continue, the 10-year yield is expected to fall further.
"The Fed is about to embark on a significant rate cutting exercise, and history shows that the 10-year rate tends to fall both in anticipation of cuts … and on actual delivery of cuts," said Padhraic Garvey, head of global rates and debt strategy at ING.
This means that the 10-year yield could have significantly further to drop.
"Bottom line: There are good reasons to anticipate the resumption of a much steeper curve," Garvey said.