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As interest rates rise, investors can't decide whether the bond market move is cause for confidence or concern

Key Points
  • Treasury yields rose Thursday after hawkish Fed speakers emphasized that more rate hikes are on the way.
  • The 10-year yield jumped to a four-week high of 2.91 percent.
  • The 2-year has also moved higher, and the gap between the 10-year and 2-year yields narrowed to an 11-year low.
  • Even though it has moved higher, the 10-year yield has not moved as aggressively as the 2-year, suggesting to some bond market pros that it reflects the eventual slowing of the economy, inevitable after a Fed rate hiking cycle.
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U.S. stocks trade lower as rising rates spook investors

The bond market's conundrum is back.

The Treasury market is flashing two messages: The Federal Reserve is serious about raising rates, but at some point that could choke off economic growth.

Treasury yields moved higher this week, as a flurry of Fed speakers reaffirmed the central bank's commitment to gradually raise interest rates.

At the short end, the 2-year yield rose to 2.436 percent Thursday. It is the yield most reflective of Fed policy and has been moving higher at a faster rate than the 10-year yield, the benchmark and the one used to price mortgages and a myriad of other consumer and business loans. That yield was at 2.91 percent Thursday, a four week high.

The more aggressive move by the 2-year has created a "flattening" or a narrowing of the gap between the two yields, now at its flattest point since 2007. A flattening curve is seen as a signal of a potential weakness in the economy down the road, while an inverted curve signals recession. The curve would 'invert' when the 10-year yield is actually lower than the 2-year.

"This is the conundrum all over again," said Ian Lyngen, head of U.S. rate strategy at BMO, echoing a comment once made by former Fed Chairman Alan Greenspan about the bond market. "We're hiking rates, and we don't understand why long end rates aren't going up."

Some bond pros see the lower long end rates as a warning of what the economy might be like when the Fed reaches the end of its hiking cycle. The logic is as the Fed raises interest rates, and mortgage rates and interest rates on other loans rise, the economy is subject to slowing.

"A Fed that is going to continue at a pace with tightening expectations and get the fed funds into the mid 2 percent to low 3 percent range, would put the brakes on the economy," Lyngen said.

The Fed raised interest rates by a quarter point in March, taking its benchmark funds rate to a target of 1.5 percent to 1.75 percent. It was the sixth rate hike since the Federal Open Market Committee began raising rates off near-zero in December 2015. The Fed has forecast two more rate hikes for this year, but some market participants believe there could be more.

The funds rate is closely tied to consumer interest rates, which pretty much rise as soon as the Fed hikes. The Fed speakers this said they continue to see gradual rate hikes, and expect inflation to move toward its target of 2 percent.

"The front end is responding to the Fed action and the long end is saying we don't think there's going to be an inflationary breakout here. The Fed is going to keep it under control," said John Briggs, head of strategy at NatWest Markets.

San Francisco Fed President John Williams played down the flattening curve this week and said he doesn't expect the yield curve to invert. He also said the flattening is normal part of the rate hiking process. Williams becomes president of the powerful New York in June.

"I personally don't anticipate having an inverted yield curve in the next few years," he told reporters. "I would see an inversion of the yield curve as a warning sign that sentiment is that growth is going to slow markedly."

Michael Schumacher, director rate strategy at Wells Fargo, said the yield curve's move has been more dramatic lately, but he doesn't think it's the indicator it was in Greenspan's day.

"If this was 2005, I'd say that was a good signal, but right now I don't see it," he said. "Central banks have piles of bonds and that's fouled up a lot of mechansims."

Schumacher said besides the affect of the Fed holding trillions of dollars in bonds, the 10-year yield is also sensitive to international rates. With sovereigns like the bund at very low levels, that keeps a lid on U.S. long rates.

"I do think it reflects Fed tightening, but I don't think it reflects a recession. The rates market is not telling us much about the economy right now," Schumacher said.

The flattening has also been going on for well over a year, and on Wednesday, the gap was just 43 basis points. Schumacher said at the start of 2016, the spread between the 2-year yield and 10-year was 135 basis points, and it flattened to 52 bps by year end, a move of some 80 points. But it then steepened early this year, reaching 78 on Feb. 12, before flattening again.

Treasury yields were also higher Thursday on solid economic reports, and relief that some of the political tensions over Syria and trade have faded into the background for now. Yields move opposite price and were also rising in tandem with a jump in the German bund yield, now at 0.59 percent.