The spread between 2-year and 10-year U.S. Treasury note yields has seen its deepest inversion since 1981, highlighting market fears that a protracted Federal Reserve rate hiking cycle might push the U.S. into a recession. The inversion, which occurred early on Monday, reached -109.50 basis points, surpassing the inversion levels seen during the U.S. regional banking crisis in March. Market players have begun pricing in potential additional rate hikes for the current year in response to indications of U.S. economic strength and a desire to control inflation.
Changes in market expectations have seen rate cuts initially expected for the central bank's September meeting shifted to January. Ian Lyngen, head of U.S. rates strategy at BMO, attributes the lack of a significant round of dip buying to uncertainty around policy outlook. Lyngen believes that a more balanced market tone will replace the prevailing bearish bias once investors gain confidence in Powell’s vision of terminal rates.
Historically, yield curve inversions - situations where shorter-dated Treasuries trade at higher yields than longer-dated securities - have been reliable indicators of impending recessions. The inversion of the 2/10 year yield curve has been seen from six to 24 months prior to each recession since 1955, with only one false signal during this period, according to a 2018 report from the San Francisco Fed.
As of July last year, the spread between 2 and 10-year Treasuries has remained inverted. On Monday morning, the 2-year U.S. Treasury yield, typically aligned with interest rate expectations, rose by 3.6 basis points to 4.913%. The yield on 10-year Treasury notes increased by 1.2 basis points to 3.831%.
