Treasury yield curve inversion can deepen

“Clients should hold curve flattening positions until inflation and employment data moderate, given the possible further upward repricing of the terminal rate.”

Bank of America

NEW YORK: How much further the US Treasury yield curve inverts depends on changes in the expected peak in the Federal Reserve’s (Fed) policy rate, according to Bank of America (Bofa).

“The extent of inversion will depend on the terminal rate, which will likely be a function of inflation,” Meghan Swiber, director of US rates strategy at Bofa, said in a report.

The two-year Treasury yield exceeded the 10-year by nearly 50 basis points, a milestone last seen in August 2000, based on expectations that the Fed’s rate will peak at around 3.5%, from a current range of 2.25% to 2.5%.

If the expected peak rises a half point to 4% with no change in the market’s assessment of the neutral rate of monetary policy, the curve inversion has scope to 85 basis points, Swiber wrote.

If the neutral rate rises as well, a half-point increase in the terminal rate might flatten the curve to only 60 basis points, she wrote.

Attention is keenly focused on the yield curve slope as sustained inversions in past decades have been followed by economic downturns over the ensuing 12 to 18 months.

During April 2000 – a time when the US Treasury was buying back debt and the Fed was tightening policy – the two to 10-year curve inverted as much as 56 basis points.

While inversions beyond 50 basis points in recent decades have been rare, “there is no natural limit on how inverted the 2s10s curve can go,” Swiber wrote.

The prospect of a hard landing for the economy, “will likely skew curves flatter as hikes near term will probably be viewed as needed cuts in the future”.

There is no historical precedent to indicate that an economy in recession can produce 528,000 jobs in a month, as the United States did during July. A 3.5% unemployment rate, tied for the lowest since 1969, is not consistent with contraction. But that doesn’t mean there isn’t a recession ahead.

If growth remains strong, “the curve may continue to flatten but to a lesser extent with longer-dated tenors also supported”,

Bofa said clients should “hold curve flattening positions until inflation and employment data moderate, given the possible further upward repricing of the terminal rate.”