Yield Curve Flattens As 2-Year Treasury Rate Rises Above 2%

The 2-year Treasury yield is above 2% for the first time in nearly a decade. This rate, which is seen as a key proxy for monetary policy expectations, ticked up to 2.03% on Tuesday (Jan. 16), based on daily data via Treasury.gov. The increase, coupled with a fractional dip in the benchmark 10-year Treasury yield to 2.54%, squeezed the widely followed spread 10-year/2-year spread to 51 basis points, matching the low reached last month that marks the smallest difference since 2007.

The futures market is currently predicting that the Federal Reserve will keep its target rate unchanged at the current 1.25%-to-1.50% range when policymakers meet on Jan. 31. By contrast, the probability of a rate hike is roughly 74% for the March 21 FOMC meeting, according to CME data this morning.

Some analysts are expecting the 10-year/2-year spread will dip into negative terrain later this year, which is to say that 2-year rate will rise above its 10-year counterpart. BMO’s Ian Lyngen and Aaron Kohli wrote in a report yesterday that “2018 will be the year the curve flattens to inversion,” courtesy of the Fed’s ongoing plan to raise rates.

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An inverted yield curve is generally considered a bearish sign for the economy, marking an increase in US recession risk. But economic risk is low at the moment amid solid growth that’s expected to continue for the foreseeable future. For example, the Atlanta Fed’s current estimate for 2017’s report on fourth-quarter GDP that’s due next week calls for a healthy 3.3% rise, slightly above Q3’s 3.2%.

A positive outlook is also the consensus view for major economies around the world. “The global economy is firing on all cylinders,” says Paul Mortimer-Lee, chief market economist at BNP Paribas. As a result, “Treasuries will feel the heat.”

Indeed, a set of moving averages continues to point to rising yields in the near term. For the 2-year yield in particular, the technical profile suggests that the upward bias will roll on.

Note, too, that the outlook for the 10-year yield also calls for higher rates, a shift from the downward bias that prevailed on this front through most of last year until the fourth quarter. If the current forecast is right, the Treasury yield curve widen, providing support for expecting a positive economic trend.

A complicating factor may be the outlook for higher inflation. The Treasury market’s implied inflation forecast via the yield spread for 10-year Notes, for example, continues to hold above the 2% mark – the highest level since last spring.

The worry in some corners is that a firmer economy, supported by the recent round of tax cuts, could lift inflation too far and too fast for Fed policymakers. “Tax reform is a good idea, but what wasn’t was such a big tax giveaway to business at a time when the US is close to full employment,” notes Mortimer-Lee. “The market and economy could wind up overheating.”

Using the 2-year yield as a guide, the crowd appears increasingly inclined to price that risk into the market. The question is whether the benchmark 10-year yield will align with that view in the weeks ahead and bring a steeper yield curve in the process? That’s a distinct possibility, according to the forecast via the moving averages for rates in the charts above.

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