Treasury yields continue slide with traders wary of 'curve inversion'

NOTE: The bond market will be closed Dec. 4, 2018 to observe the funeral of President George H.W. Bush.

U.S. government debt yields sank Tuesday as fixed-income investors continued to doubt expectations of burgeoning inflation and sustained economic activity amid more dovish commentary from the Federal Reserve.

On Monday, a portion of the so-called yield curve inverted, a phenomenon characterized by short-term rates that exceed long-term rates. As of Tuesday afternoon, the yield on the benchmark 2-year Treasury note hovered at 2.799 percent, above the yield on the 5-year note at 2.79 percent. The closely followed spread between the 2-year Treasury note yield and the 10-year Treasury note yield remains positive, but flattened to just 11 basis points.

Short-term yields, impacted by changes in Fed policy, have been anchored in place in recent months as Chair Jerome Powell led his colleagues in three increases to the overnight lending rate. In contrast, inflation and economic expectations dictate the movement of long-term rates; investors estimate how much they should be compensated beyond inflation for holding government debt over several years.

The difference between the 5-year Treasury inflation-protected securities, or TIPS, and the corresponding Treasurys hit 1.72 percentage points last Tuesday. That spread is a practical look at the market's projection of where inflation is heading, and is down from highs over 2 percent in October. The closely followed spread between the 2-year Treasury note yield and the 10-year Treasury note yield remains positive.

There has been "a tremendous move in the long-end as short rates have hardly moved and 30-year bonds are up five-eights of a point. I believe a lot of this move is a function of portfolios liquidating credit and equity exposure in favor of
long-dated Treasurys," wrote Tom di Galoma, head of Treasury trading at Seaport Global Holdings.

"The move into the long-end is also recessionary (12-18 months out) as the curve continues it way towards full inversion of the 2-year, 10-year spread," he added.

The yield on the benchmark 10-year Treasury note fell 7 basis points to 2.915 percent at around 4:38 p.m. ET, while the benchmark on the 30-year Treasury bond was also lower, trading at 3.17 percent. Bond yields move inversely to prices.

Meanwhile, DoubleLine CEO Jeffrey Gundlach told Reuters he believes that the recent inversion of the U.S. Treasury yield curve is a signal that the economy is set to weaken. The so-called "bond king" told Reuters that the phenomenon is predicting that the "economy is poised to weaken."

He also told Reuters the "totally flat" Treasury note curve will "stay the Fed's hand" on future hikes to the federal funds rate.

With bond traders expecting returns in the next two years to exceed those in the next five, inversions typically portend economic recession. Though there is a high correlation between a yield curve with a negative slop and economic recession, the time between inversion and GDP contraction often varies and is difficult to predict.

While there was much disagreement between investors on when to expect a recession, traders voiced unified concern that the Fed's inflation predictions have been too optimistic.

"I think ever since Jay Powell's speech we have assumed that the Fed is nearing a pause," said Kevin Giddis, head of fixed income capital markets at Raymond James. "I don't know if that's true but the benefits are that 10-year rates have likely peaked around 3.25 percent a few weeks ago, and that we'll probably finish the year sub 3 percent."

"The Fed is getting on board with where the bond market was all along on inflation," he added.

Symbol
Yield
 
Change
%Change
US 3-MO
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US 1-YR
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US 2-YR
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US 5-YR
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US 10-YR
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US 30-YR
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Powell said last week that the benchmark interest rate was "just below" the neutral level — meaning one that would neither speed up nor slow down economic growth. That remark appeared to backtrack from a previous statement by Powell in which he said rates were still a "long way" from the targeted neutral rate.

Giddis added that with all eyes on inflation, the Labor Department's report on the employment situation on Friday will be key for Fed officials. The government's November jobs numbers will also include an update on average hourly earnings, which can be used to see how fast wages are rising across the U.S. economy.

If wages are rising at a quick pace, Fed members may be more apt to continue to hike interest rates to try to stay ahead of inflation. The Federal Open Market Committee, which sets the federal funds rate, will gather for a two-day meeting on December 18, where the central bank is strongly expected to hike interest rates.

— CNBC's Sam Meredith and Ryan Browne contributed to this article.