In the spirit of the Passover story, the yield curve is set to go further into the wilderness of inversion, suggesting that a recession is on its way at some point.
Greg Peters, co-chief investment officer at PGIM Fixed Income, told Bloomberg TV that he expected the yield on the 2-year Treasury to rise by at least 100 basis points above the 10-year.
As of Wednesday, April 5, the 10-year's yield was 3.30% and that of the 2-year was 3.79%. To hit that 100-basis point difference would require at least an additional 51 basis points in spread.
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Peters sees a larger gap between the two financial instruments as a possibility because inflation is still high, but he thinks many investors assume that the Federal Reserve will soon cut interest rates.
As the Federal Reserve Bank of St. Louis has noted, different term Treasurys have varying relationships with the benchmark federal funds rate that the Fed sets. The 1-year and fed funds rate track each other closely. The 10-year isn't close. The 2-year also tracks the fed funds rate very tightly. Cutting the fed funds rate would typically bring down both the 1- and 2-year bonds.
"Inflation remains quite high, so I don't see the scope for central banks, namely the Fed here, cutting rates in the manner that the markets are suggesting," Peters said.
As always, a yield curve inversion is not an absolute guarantee of any specific economic outcome.
A yield curve inversion, with interest rates on shorter-term bonds being higher than on longer-term, frequently is followed by a recession within a year or so. The explanation is that collectively investors perceive the economy will slow over the longer run, with the Fed lowering short-term rates to prevent a recession. That means when bonds come to maturity, rates will be lower and investors won't make as much by reinvesting, so they demand higher interest rates on short-term bonds to make up the difference.
But the relationship can be tricky. In July 2019 there was an inversion between the 10-year and 3-month Treasurys. And there was a recession in 2020, however global shutdowns of businesses and supply chains were independent factors.
Peters said that a soft landing was still possible, but the recent banking problems increased the risk of a recession.
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