Yield Curve Inversion Reaches New Extremes

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Unusual relationship between Treasury yields reflects investors’ bets on easing inflation and future rate cuts

Yields on longer-term U.S. Treasury’s have fallen further below those on short-term bonds than at any time in decades, a sign that investors think the Federal Reserve is close to winning its inflation battle regardless of the cost to economic activity.

A scenario in which short-term yields exceed long-term yields is known on Wall Street as an inverted yield curve and is often seen as a red flag that a recession is looming.

Yields on Treasurys largely reflect investors’ expectations for what short-term interest rates set by the Fed will average over the life of a bond. Longer-term yields are generally higher than shorter-term yields because investors want to guard against the risk of unexpected inflation and rate increases.

At a basic level, an inverted curve means that investors are confident that short-term rates will be lower in the longer-term than they will be in the near-term. Typically that is because they think the Fed will need to slash borrowing costs to revive a faltering economy.

The yield curve is more than just a little bent out of shape at the moment.

Last week, the yield on the 10-year U.S. Treasury note dropped to 0.78 percentage point below that of the two-year yield, the largest negative gap since late 1981, at the start of a recession that pushed the unemployment rate even higher than it would later reach in the 2008 financial crisis.

Still, many investors and analysts see reasons to think that the current yield curve may presage waning inflation and a return to a more normal economy, rather than an approaching economic disaster.

The current yield curve is “the market saying: I think inflation is going to come down,” said Gene Tannuzzo, global head of fixed income at the asset management firm Columbia Threadneedle.

By Sam Goldfarb

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