By Karen Brettell

NEW YORK (Reuters] – The dramatic flattening seen in the U.S. Treasury yields shows that worries have been raised about the Federal Reserve’s slowness to increase interest rates. This could indicate the Federal Reserve will be putting off raising them too much and risking causing a recession.

After Thursday’s strongest annual inflation data in 40 years, the gap between the yields of U.S. government bonds on two-year or 10-year terms is at its smallest level since July 2020.

For insight into the U.S. economic situation, investors watch the yield curve. The inverted curve is one where the rates of short-term government debt are higher than those for longer-term debt. This has been reliable to forecast past recessions.

Investors fear that the Fed may have let inflation spiral out of control and is slow to raise interest rates. This could cause the yield curve to flatten. It also risks causing growth problems as the Fed scrambles for catch-up.

“On the one hand, the market is saying this is what the Fed is going to be doing, and on the other side it’s saying ‘oh by the way, it’s going to be a mistake,’” said Tom Fitzpatrick, chief technical strategist at Citi.

Investors have begun to price in 175 basis points for interest rate increases next February. There is a 62% probability that the Fed would raise rates 50 basispoints at its March meeting. An increase of 25 to 25 basis points is expected in March. [FEDWATCH]

The curve between two-year and five-year notes, which Fitzpatrick calls his “financial bible” because of its historical accuracy in forecasting the outcomes of Fed policy, briefly reached 30.4 basis points, from 66 basis points a month ago, and was last at 36 basis points.

Fitzpatrick stated that every time the yield gap fell below 31-33 basis points in the last 25 years, it ended up inverting. This happened in Fitzpatrick’s 2000, 2006, and 2019 instances. Each of these cases saw economic contractions and stock market drops. The most recent was caused by the closing down of businesses in the wake the pandemic.

Flattening in yields between 5 and 10 years, where there is currently a spread of only 9 basis points, indicates that the Fed has not been quick to respond as the economy improves.

“The bond market is saying that we’re in a bit of a boom here and the Fed has a lot of work to do,” said Padhraic Garvey, regional head of research, Americas, at ING.

As a recession indicator, the two-year and 10-year yield curves will be closely monitored. A downturn in economic activity is likely to occur six months or two years after it reverses. The yield curve reached 38 basis point on Monday before rebounding to 45 basis point.

However, this area remains flat in comparison to previous tightening cycles. Another recession indicator is the spread between 3-month bills and 10-year bonds. This is according to Deutsche Bank (DE:).

That part of the curve “tells us that the current shape of the yield curve is not too drastically different from the beginning of past tightening cycles, once the expected total number of hikes is factored in,” Deutsche Bank strategist Steven Zeng said in a report.

While the spread between these yields is approximately 160 basis points the market prices in 200 basis point cumulative increases by the Fed’s end of its tightening cycle, If 10-year yields rise by 40 basis points during the rate hikes, “the curve would avoid a complete inversion,” Zeng said.

While the flattening curve is attracting attention, most market participants don’t see a recession on the horizon. Fund managers in a BofA Global Research survey, released Tuesday, named hawkish central banks as the top “tail risk” to markets. Although the expectation for a flatter yield curve was the most since 2005, only 12% said that a recession would occur in the coming year.

Additionally, the Fed may use its enormous balance sheet to roll out or possibly sell bonds to tighten conditions. It can also re-steepen curves to give itself more flexibility to increase rates.

“If you use the balance sheet and longer-end yields continue to push higher and the curve continues to steepen, that kind of validates that you can continue on your path in terms of short-term interest rates,” said Citi’s Fitzpatrick.

Esther George, President of the Kansas City Fed said that shrinking its balance sheet might allow it to follow a more shallow path in interest rate rises.