U.S. government-issued debt is reportedly signaling investors that the U.S. economy could be on shaky ground. The U.S. yield curve, which charts the course of interest rates for various government-issued debt, flattened last week. This repricing in the markets comes amid a shift toward aggressive monetary policy by the Federal Reserve in the face of soaring inflation exacerbated by war in Ukraine. Â
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Traders and economists alike look to the yield curve as a sign of the economy’s health. As policymakers have sought to rein in inflation without disturbing economic growth, a flattening yield curve suggests that their efforts could be futile.
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Energy analyst John Kemp tweeted that a flattening of the U.S. yield curve indicates a “high probability” of either a “mid-cycle slowdown” or an “end-of-cycle recession” in the coming 12 months.Â
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The bond markets have been in a tailspin since the Fed indicated that an interest rate cut in the 50-basis point range could be ahead. The U.S. bond market has not been in such a state since 2016.
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Last week, the yield curve spread on 2- and 10-Year Treasury notes displayed a gap of 24.5 basis points, 60 points lower than year-end 2021 levels. Â
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Generally, the yield curve’s default shape is an upward slope, illustrating the gamble investors are willing to take that inflation and interest rates will not diminish their returns on longer-term debt securities.Â
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Shorter-term yields, meanwhile, reflect investors’ expectations for the tone of monetary policy in the foreseeable future. Â
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Image by Financial TimesÂ
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If things worsen and the yield curve begins to point downward or become inverted, it serves as a sign that a recession could be up ahead. This scenario unfolded in 2019, before the pandemic-fueled downturn of 2020.
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In fact, an inverted yield curve has reared its head before each of the economic recessions that the U.S. economy has suffered in the past 50 years. Â
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Bond issuing is currently a tale of two markets. Short-term yields are climbing steadily higher as investors brace for tighter monetary policy in which multiple interest rate hikes are in the cards. The yield on the 2-Year Treasury note, for example, is hovering at 1.94%, up more than 160% compared to year-end 2021 levels. Â
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On the other hand, the yields on long-term government bonds have been moving at a snail’s pace amid the belief that a more aggressive Fed will translate to an economic slowdown. The result is a flattening Treasury yield curve.
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As traders hope to stave off an inverted yield curve, the U.S. economy remains in the woods, with the threat of short-term yields surpassing long-term yields before year-end still looming.