The inverted spread between 10-year U.S. Treasuries and two-year bonds is 78 basis points, the largest negative gap since 1981.
“The yield curve is more than just a little bent out of shape at the moment,” as The Wall Street Journal puts it.
However, rather than reading this as a flashing red sign that a recession is looming—as it did in late 1981 at the start of a downturn that saw more job losses than in the Great Recession of 2008—investors are cheering.
That’s because they see it as an indication that the U.S. Federal Reserve is winning its battle against inflation, regardless of any short-term economic pain.
“The market is saying, ‘I think inflation is going to come down,’” says Gene Tannuzzo, global head of fixed income at Columbia Threadneedle.
It also underscores faith among institutional investors that “the Fed does have credibility,” Tannuzzo adds. “Ultimately, the Fed will win this inflation fight. In the meantime, we have to bear higher short-term interest rates.”
What began triggering the yield curve inversion and raising the outlook on inflation was better-than-expected consumer price index (CPI) data from the Labor Department, 7.7%, earlier this month.
A 5% target fed funds rate by early 2023 is now priced into the market—up from its current 3.75%-4% level.
Those who are even more optimistic think the Fed will even begin to cut interest rates to stimulate the economy in late 2023.
Federal Reserve Chairman Jerome Powell will be speaking at the Brookings Institution Wednesday at 1:30 p.m. EST, and investors are eagerly awaiting his remarks.
On more than one occasion hawkish comments from Powell have dowsed rallies in stocks and bonds, by saying that the Fed may not raise rates but is prepared to keep them at elevated levels for a longer than investors would like.
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