In the equity market, everything seems to be in reasonable order as stocks chase one high after another, albeit with occasional setbacks. But the bond market is sending a different signal.
This week, the yield on short-dated Treasury debt rose faster than on longer-dated Treasury debt. At the close of trading on Friday,
notes were yielding 47.9 basis points, or hundredths of a percentage point, more than
debt. That compares with a gap of 45.9 basis points on Thursday and was the biggest differential so far this year.
Such a gap, or inversion, when investors get paid more for owning shorter-term government debt than for longer-dated securities, tends to suggest rougher economic conditions. The yield curve, plotting the returns on debt maturing at different times, has been inverted for the longest time in U.S. history, and there is little sign that it is coming to an end.
At first glance, it makes sense. The shorter end of the curve is more influenced by the Federal Reserve’s monetary-policy actions and this week’s commentary from central bank officials axed any expectations for a summer rate cut. Predictions that near-term interest rates will be higher for longer as the Fed keeps fighting inflation, plus solid data on claims for unemployment benefits, have taken the 2-year yield dangerously close to the 5% level.
“Bond markets on verge of breaking to higher yields…10 Yr not there,” wrote Andrew Brenner, head of international fixed income at NatAlliance Securities, shortly before heading to the beach for a walk on Friday.
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As Wall Street celebrates the Memorial Day break, there are at least two stories being told about why the 10-year yield, which is responsive to economic growth, has been lagging behind the two-year to make the curve even more deeply inverted.
Brenner says investors dealing with the two ends of the curve seem to be focusing on different things. “The long end seems to be paying attention to a weakening economic scenario, but the short end is under fire from the Fed and some of the mixed recent numbers,” he wrote.
Expectations that the economy will slow, which would make rate cuts more likely, is a reason investors may be buying longer-dated debt now, locking in the current relatively high yields.
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The Fed’s balance sheet is the other factor. The Federal Open Market Committee has decided that starting in June, it will let $25 billion of its bond portfolio mature monthly without using the money to buy more debt, compared with $60 billion currently.
The net effect is that more Fed money will flow into the Treasury market, which can drive up prices and push yields lower. That expected buying may already be weighing on longer-dated yields. New York Fed’s website shows that 34% of the Fed’s holdings of Treasuries mature in 10 years and over, the highest allocation to any group of maturities.
Investors should watch out for next week’s auctions of Treasury debt. Barry Knapp, managing partner of Ironsides Macroeconomics, says the sales could “put pressure on the back end,” taking the yield higher and prices lower. That may reduce the yield-curve inversion, if yields at the shorter end hold steady or decline.
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Wall Street, for now, can enjoy the sunny weather and the long weekend. Until Tuesday.
Write to Karishma Vanjani at karishma.vanjani@dowjones.com.
