US Treasury Yields: The Disappearance of "Inverted Yield Curve"

The 2-year and 10-year U.S. Treasury yield spread is considered an important indicator by the market. During this round of Fed rate hikes, the 2-year and 10-year Treasury yields once inverted, which is generally seen as an early signal of a possible economic recession.

However, this tried-and-true signal has been repeatedly proven wrong in the past two years, as the U.S. economy has shown increasingly stable growth amidst widespread pessimism, and the "recession" hypothesis has yet to materialize. With the Fed's rate cuts looming, the yield spread between 2-year and 10-year Treasuries has continued to narrow and recently approached disappearance. What does the disappearance of the inversion signify? That is the question we hope to discuss today.

Let's first look back at the trend of the 2-10 year Treasury yields. Since July 2022, the 10-year Treasury yield has been higher than the 2-year Treasury yield, and the yield curve inversion has persisted until late August 2024, spanning over two years.

With the fluctuations in U.S. inflation in this round, the yield curve inversion can be roughly divided into 4 stages. In the first stage, from July 2022 to July 2023, as U.S. inflation issues worsened, there was a widespread expectation of Fed rate hikes in the market, leading to a faster pace of increase in short-term rates compared to long-term rates, with the spread widening to -108 basis points.

In the second stage, from July 2023 to October 2023, U.S. inflation had been preliminarily alleviated, and there were basically no concerns about rate hikes in the market. However, the stickiness of inflation began to be recognized by the market, with long-term rates gradually rising, and the spread narrowed to -14 basis points during this period.

In the third stage, from November 2023 to July 2024, the U.S. inflation issue significantly improved, but inflation was further hindered by stickiness. Despite market expectations of rate cuts, the yield spread between long and short-term Treasuries remained relatively stable.

In the fourth stage, from July 2024 to the present, the market gradually confirmed that the Fed would start cutting rates, leading to a rapid decline in short-term Treasury yields. However, medium to long-term inflation issues persist, with the pace of decline in long-term Treasury yields relatively slow, and the spread basically disappearing by the end of August 2024.

Based on the above analysis, it can be seen that the financial market's perception of inflation largely determines the state of the yield curve. From the chart below, we can also see that the trend of the U.S. core CPI has been leading the trend of the 2-10 year Treasury yield spread in recent years.

However, when comparing the 2-10 year spread with GDPNow, we find that their correlation is not significant. Such comparisons also reveal that the "unpredictability" of inflation in recent years has become the core variable driving the yield curve.

From the perspective of monetary policy response, as inflation begins to rise, the market worries about an economic hard landing, leading to an inverted yield curve. But as inflation stabilizes, the yield curve gradually smooths out, and the inversion gradually disappears, indicating a significant reduction in market concerns about an economic recession

Of course, for the market, the real issues that need to be addressed are the following two. The first is the shape of the future interest rate curve, especially whether term premiums will reappear. The key to answering this question lies in the judgment of the "new steady state" of the U.S. economy. That is to say, if the market broadly accepts a new inflation center, and the U.S. inflation rate remains near the new center, then rate cuts will be smoother, which will stabilize the level of the 2-year U.S. Treasury yield and investors will gradually price in new term premiums.

Currently, the market's view on the new nominal neutral interest rate in the U.S. is increasingly close to 3.5%. However, this rate level still needs more data and time to validate. Assuming this level holds, we can roughly consider the bottom of the 2-year U.S. Treasury yield to be around 3.5%. Based on historical experience, a term spread of 50 basis points should not be excessive, so the level of the 10-year U.S. Treasury yield may be at 4% or higher.

A more pressing issue for the market may be whether the interest rate curve can predict the economy. From past experience, the predictability of the interest rate curve for the economy is not ideal. If investors are to rebuild confidence in the interest rate curve, a new validation process will be necessary.

From this perspective, only when the interest rate curve significantly diverges from market consensus and is revalidated, can the predictive ability of the interest rate curve be reestablished. This process is likely to last for several years, meaning that in the foreseeable quarters, the interest rate curve will probably only have a mutually confirming relationship with short-term economic trends. At the same time, when inflation fluctuates, the interest rate curve may follow the trend of inflation, and only when inflation gradually stabilizes, can the interest rate curve better reflect the form and expectations of the economy. In other words, in the coming quarters, the market should not overly focus on the interest rate curve and term premiums.

Author: Zhou Hao S0880123060019, Sun Yingchao; Source: Guojun Overseas Macro Research; Original Title: "U.S. Treasury Yields: The Disappearance of the 'Inversion'"