By Gertrude Chavez-Dreyfuss

NEW YORK (Reuters] – The U.S. Treasury yield curve has diverged from the expected direction, raising concerns about whether central bank bond purchasing and other factors are affecting the economy’s trajectory.

Spread between 10-year Treasury notes and Treasury bills for 3-months has increased this month. This can signal economic growth. This curve reached its highest level in five years on Friday at 196 base points.

However, the U.S. 2-year and 10-year curves have flattened significantly this year, close to inverting. The longer maturity would produce less than the shorter.

Graphic: US yield curves: https://fingfx.thomsonreuters.com/gfx/mkt/lbvgnmbnkpq/US%20yield%20curves.PNG

As investors seek a better return for longer-term debt, they tend to see yield curves that slope upward as there is a higher chance of inflation and default.

A steepening curve usually signals stronger economic activity, greater inflation and higher interest rate expectations. Flattening curves indicate investors are less confident in the economic growth outlook.

Inversions can be a sign of recession. The signal isn’t clear right now.

Ben Emons is the managing director for global macro strategies at Medley Global Advisors. “There’s a technical issue.” The 3-month Tbill yield remains lower because it does not reflect future rate increases. It will increase as the Fed raises rates.

Emons noted that U.S. yields on two-year bonds are a good indication of Federal Reserve policy for the coming two years. It’s also showing an even steeper trend of rate rises.

On Monday, the spread between 2s/10s was at 20.10 base points. It has since been compressed to 11.4 base points on Monday, the tightest it had been since March 9, 2020 before the outbreak of the coronavirus pandemic.

Short-term interest rates were raised by 0.25 percent last week by the Fed, its first increase since December 2018. U.S. rates futures priced in an approximately 75% probability of the Fed tightening its monetary policy in May by averaging a quarter-percentage point. The futures market anticipates that the Fed will increase its cumulative rate by 200 basis points in 2022.

According to Dan Belton at BMO Capital, fixed income strategist Dan Belton said, “If policy evolves as market anticipates, then the 3-month/10 year curve will begin to flatten when more rate increases become priced into 3-month tenor.”

The market pricing an increasingly hawkish Fed in the coming two years is evident by the divergence between 3-month Treasury rates and 2-year Treasury rates.

Last time that 3-month/10-year curve was reversed, it was February 2020. One month later, as economic turmoil caused by the global coronavirus pandemic, the Fed reduced the overnight benchmark lending rate to close zero.

According to BoFA Securities, the 2s-10s inversions preceded all eight of the most recent recessions (including 10 of the 13 last years), according BoFA Securities research notes. In 2019, the last time that this curve was reversed, it was 2019. This curve inverted once more, but it was reversed again in 2019.

Graphic: US yield curves/Fed tightening: https://fingfx.thomsonreuters.com/gfx/ce/akvezjmzwpr/Pasted%20image%201648228471373.png

U.S. CURVE 2s/10s HAS QUESTIONS, TOO

However, the yield curve for 2-years/10-years has technical problems and many aren’t convinced that it is telling the truth.

Gennadiy, senior rates strategist at TD Securities said, “Something as 2s/10s, 5s/30s would definitely tell you we’re a much flatter than we ever have been at the beginning of a hiking season.”

The Fed purchased a lot of Treasuries during its COVID QE program (quantitative easement). Analysts claim that Fed QE in the past two years has produced a lower U.S. 10-year yield, which could explain the differences in both yield curves.

Stan Shipley from Evercore ISI New York, fixed income strategist, said that research suggests that the 10-year yield will be about 3.60% if there is no stimulus. Shipley stated that the yield on the 10-year will increase to fair value if the Fed begins shrinking its balance sheets through quantitative tightening.

Last Friday’s U.S. 10-year yield reached 2.475%. It had risen to 2.5% on Friday. That was the highest point since May 2019.

Shipley explained that “Without QE/balancesheet expansion, there would be a 10-year spread and a 2-year spread around 140 basis point, which is not threatening” and was consistent with the 3-month spread.

Evercore Analysts believe that the 10-year yield will approach fair value by the second half of 2024. That’s 120 basis points above the current level.

Shipley believes that the U.S. 2-year yield is well-priced and will increase the 2s-10s curve.

What does this mean for America’s economy?

Timothy Graf, EMEA macro strategist, said that some of the 2-10 shapes are due to Fed cycles being more expensive than normal. The notion of when the Fed will move quickly is also very front-loaded. State Street (NYSE:).

“I think there will be a slowdown in the growth but could it cause recession?” This could be the story next year. While households may want fuel prices to drop, overall household balance sheets remain in good standing.