Signs of Steepening

In March, we wrote that the Treasury yield curve was sound asleep. Since then, a quick inversion has jolted it awake.

As shown in the LPL Chart of the Day, the spread between the 2-year and 10-year Treasury yield has climbed for four straight weeks, the longest streak since November 2016. That spread fell to near a cycle low at the end of March, the same time the three-month to 10-year yield spread inverted (long-term rates fell below short-term rates).

Yield Curve Wakes Up After Brief Inversion

The 10-year yield closed below the 3-month yield from March 22 to March 28. Since then, the longer end of the curve has perked up, boosting the 2-year and 10-year spread to a two-month high of 20 basis points (0.20%).

“We’ve been encouraged by the recent recovery in long-term yields as global data have improved,” said LPL Research Chief Investment Strategist John Lynch. “As the year progresses, sound economic fundamentals should eventually prevail over global uncertainty.”

Bond investors have increasingly focused on the shape of the yield curve over the past few years as the Federal Reserve’s (Fed) rate hike campaign boosted short-term yields at a faster pace than long-term yields. Yield curve inversions have preceded previous recessions, although inversions right before a recession have typically been deeper and prolonged.

The yield curve is still historically flat, but we see signals that longer-term steepening could be in process. Economic data have noticeably improved over the past several weeks, and inflation remains healthy. Buying pressure in Treasuries has also likely eased as rates have picked up globally amid progress in U.S.-China trade talks. The Fed has also committed to patience until there is more clarity on global conditions, giving the curve some breathing room to normalize.

Overall, we expect improving economic conditions and slightly higher inflation to lift the 10-year yield to 3 — 3.25% at the end of 2019. We wouldn’t be surprised to see the 2-year yield climb slightly if stronger growth forces the Fed to implement one hike in the second half of the year. Based on our forecast, we’d expect to see the 2-year and 10-year yield spread increase 25 basis points (0.25%) or more through the end of the year.

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