By Yasin Ebrahim

Investing.com – Bond traders have earned a reputation as the ‘smartest traders in the room’ but their latest flurry of bets that have flattened the Treasury yield curve —  pointing to economic doom — has left many scratching their heads.

The 10-year declined 7 basis points to 1.54% while the 2-year rose 6 points to 0.500%. This week’s yield curve flattening resulted to 104 basispoints from 116 base points. According to Reuters this was the flattest rate since late August.

The fierce battle for the yield curve’s top edge intensifies. As a result, the front-end is coming out ahead of the long-end. This causes the curve to flatten.  

This flattening can be explained by aggressive betting that Fed rate rises will come a lot earlier than people expect. It could trigger a major slowdown or recession.

“The bond market is basically saying that the Fed is going to hike rates, but because the fundamentals of the economy are weak, they may be risking a recession,” Zwei Ren, managing director and portfolio manager at Penn Mutual Asset Management, told Investing.com in a recent interview.

The latest rate-hike odds suggest that the Fed could lift rates as early as June next year, according to Investing.com’s . This aggressive betting comes amid increasing concerns about inflation.

Although the Fed’s grip on inflation is not yet in question, there is no doubt that the U.S. consumer is strong. The latest earnings report showed that spending is healthy.

This strong consumer spending which accounts for two-thirds economic growth will quickly boost the rates at the longer end.  

“Eventually, the market will realize it has been too pessimistic about the long-term growth in the U.S., and we should see increase in rates in the long-end of the curve,” Ren added.

“Demand is extremely strong in the U.S. […] this kind of momentum is going to push the economy,” according to Ren. “I see zero risk of a recession in the next 12-to-18 months.”

However, the strength of demand has hit a brick wall with supply-chain bottlenecks, which has led to high inflation and increased costs.

Supply-chain bottlenecks should largely subside but wage pressures will determine whether inflation is temporary or permanent. The Fed believes that rising wages will lead to more workers, which should boost the labor participation rate, and allow wage pressures from falling.

Investors won’t have long to wait for clues on whether the Fed’s transitory inflation narrative is wearing thin.

“The long-awaited tapering announcement is almost certainly going to be delivered [next week],” Morgan Stanley (NYSE:). “The bigger question is whether the FOMC will keep the ‘transitory’ language,” it added.

“We are leaning toward a yes, because removing it could unhinge the front end of the curve, and in turn cause an unwanted tightening of financial conditions.”