Most deeply inverted Treasury curve in more than 4 decades has one upbeat takeaway for investors

The policy-sensitive 2-year Treasury yield finished the New York session at 4.47% on Tuesday, and is up by 370.7 basis points since January, as traders factor in further Fed interest rate hikes. Meanwhile, the 10-year yield was at 3.75% — roughly 72 basis points below the 2-year yield, resulting in a deeply negative spread — and at a level that indicates traders aren’t factoring in a whole lot of additional premium based on the possibility of higher, long-term inflation.

Higher and stickier yields at the front end of the curve are “a sign of Fed credibility,” with the central bank seen committed to keeping monetary policy restrictive for longer to rein in inflation, said Subadra Rajappa, head of U.S. rates strategy for Société Générale. “Unfortunately, tighter policy will lead to demand destruction and lower growth, which is keeping long-end yields depressed.”

In theory, lower economic growth equates to lower inflation, which helps the Fed do its job of controlling prices. The million-dollar question in financial markets, though, is just how quickly inflation will come down to more normal levels closer to 2%. History shows that Fed rate hikes have no apparent maximum impact on inflation for about 1.5 to 2 years, according to famed economist Milton Friedman, who was cited in an August blog by Atlanta Fed researchers.

“The yield curve will likely remain inverted until there is a clear sign of a policy pivot from the Fed,” Rajappa wrote in an email to MarketWatch on Tuesday. Asked whether the deeply inverted curve indicates central bankers will ultimately be successful in curbing inflation, she said, “It is not a question of if, but when. While inflation should steadily decline over the upcoming year, strong employment and sticky services inflation might delay the outcome.”

Ordinarily, the Treasury yield curve slopes upward, not downward, when the bond market sees brighter growth prospects ahead. In addition, investors demand more compensation to hold a note or bond for a longer period of time, which also leads to an upward sloping Treasury curve. That’s part of the reason why inversions grab so much attention. And at the moment, multiple parts of the bond market, not just the 2s/10s spread, are inverted.

For Ben Jeffery, a rates strategist at BMO Capital Markets, a deeply inverted curve “shows that the Fed has moved aggressively and will keep rates on hold in restrictive territory despite a quickly dimming economic outlook.”

The 2s/10s spread hasn’t been this far below zero since the early years of Ronald Reagan’s presidency. In October 1981, when the 2s10s spread shrank to as little as minus 96.8 basis points, the annual headline inflation rate from the consumer-price index was above 10%, the fed-funds rate was around 19% under then-Federal Reserve Chairman Paul Volcker, and the U.S. economy was in the midst of one of its worst downturns since the Great Depression.

Volcker’s bold moves paid off, though, with the annual headline CPI rate dropping below 10% the following month and continuing to fall more steeply in the months and years that followed. Inflation hadn’t reared its head again until last year and again this year, when the annual headline CPI rate went above 8% for seven straight months before dipping to 7.7% in October.

On Tuesday, Treasury yields were little changed to higher as traders assessed more hawkish rhetoric from Fed policy makers such as St. Louis Fed President James Bullard, who said on Monday that the central bank will likely need to keep its benchmark interest rate above 5% for most of next year and into 2024 to cool inflation.

Right now, “a deeply inverted yield curve signals the Fed is somewhat overtightening, but the impact on inflation may take some time to come through,” said Ben Emons, a senior portfolio manager and the head of fixed income/macro strategy at NewEdge Wealth in New York.