The Bond Market Could Be on the Verge of Sending a Troubling Economic Signal

Short-term Treasury yields are rising faster than long-term yields. (Dreamstime)

Key Points

• The yield differential between the two-year and 10-year U.S. Treasury notes narrowed to 0.2% during a major bond market selloff.
• The benchmark 10-year Treasury yield reached a fresh 2007 high of 5.145% in early Thursday trading.
• Bets on a Federal Reserve interest rate hike in October have jumped to around 70%, with December odds pegged at more than 90%.

Sometimes the bond market whispers, as gentle moves in yields signal changes in the economic outlook that shift borrowing costs and signal broader changes in the market outlook.

And sometimes it shouts, warning about growth or inflation risks that that can have serious global implications.

Right now, the bond market’s voice is growing louder, and investors of all stripes should pay attention.

The gap between yields on the 2-year Treasury note, which largely tracks expectations of Federal Reserve interest rate hikes, and those on 10-year notes, which broadly track growth and fiscal concerns, has narrowed notably over the summer.

During the peak of Wednesday’s bond market selloff, which was by some measures the worst since Liberation Day, that yield differential was just 0.2%. That’s down from 0.70% in February and around 0.5% in August.

That’s the kind of “bear flattening” that bond traders worry about: short-term rates surging on worries over Fed rate hikes, while slower advances in long-term yields suggest tighter policy will choke off economic growth.

The next phase of that trade, however, is even more concerning, and could be in play over the coming months.

An inverted yield curve occurs when 2-year yields rise above those of 10-year notes. It generally suggests traders are more worried about Fed policy in the short term, but can also be read as a forerunner of sharply slowing growth, or even recession.

A study from the San Francisco Fed, in fact, noted that a sustained inversion preceded all of the nine recessions the U.S. economy has suffered since 1955. But that doesn’t mean the signal is totally accurate.

The last inversion, the longest on record, started in the autumn of 2022 and last for two years, as the economy crawled out of its Covid-era torpor and the Fed began its long run of normalizing interest rates from the emergency cuts it enacted at the height of the pandemic.

No recession followed, of course, thanks in part to the fiscal boost of President Joe Biden and the tech-paced growth and stock market boom triggered by the AI revolution and the launch of ChatGPT in November of 2022.

This time, however, investors are a bit more skeptical, if only because the bond market is really starting to raise its voice, and the broader debt backdrop is decidedly different.

Benchmark 10-year note yields, perhaps the world’s most important market interest rate, have been rising steadily since the U.S. war with Iran, and the notes are on pace for their longest monthly losing streak in five decades, according to Jefferies analysts.

Fiscal pressures are a factor, of course, as U.S. debt levels topped the $40 trillion market earlier this summer, and so is the surge in global crude prices, which are up more than 40% since the start of July.

The economy, too, appears to be tooling along nicely, with the Atlanta Fed’s GDPNow tracker estimating third quarter growth of 5.1%, and Wednesday’s S&P Global readings of private sector activity hitting the fastest pace in four years.

The 10-year yield hit a fresh 2007 high of 5.145% in early Thursday trading, and was last marked at 5.09%. Longer-dated 30-year bond yields hit the highest since 2004 overnight, at 5.444%, before easing to around 5.39% later in the session.

“When the 10-year Treasury yield reaches levels not seen since 2007, it changes the math for equities,” says David Miller, portfolio manager at Catalyst Funds. “Higher long-term rates raise the discount rate on future earnings and give investors a much more compelling risk-free alternative.”

But 2-year note prices are falling even faster, with yields rising to around 4.9% on Thursday, as bets on an October Fed rate hike jump to around 70%, with the odds of a move in December pegged at more than 90% on the CME Group’s FedWatch tool.

If that current pace continues, curve inversion could occur before the end of the year, just as the Fed gathers for its final rate setting meeting of 2026.

Another factor to consider is the Fed’s new policy on communication, with Chairman Kevin Warsh intent on not showing his policy cards with traditional “forward guidance,” and looking at ways to trim the central bank’s multi-trillion balance sheet in order to allow markets more transparent pricing.

“A decade of bond market manipulation isn’t normalized quickly, and without the Fed changing stances or intervening, the trend [in terms of yields] is pointed higher,” said Byron Anderson, head of fixed income at Laffer Tengler Investments.

“With a hands-off Warsh and no Fed balance sheet coming to the rescue, the yield curve doesn’t have to stop at these levels,” he added.

But is that same curve suggesting recession risk?

Probably not, according to Mark Malek, chief investment officer at Siebert Financial, who sees a solid job market, strong corporate earnings, and the AI investment race underpinning growth.

But rising yields, and a strangely moving bond market, make this a slightly more complicated mix.

“The economy is percolating away, bubbling beautifully right now, and I’m genuinely glad about that,” Malek says. “It’s just that good news isn’t free anymore. When stocks already assume everything goes right and bonds finally demand to be paid for the risk, even a booming economy can leave investors with a bill.”

“And the bond market, as usual, is the one holding the check,” he adds.

No wonder it’s speaking up.

Write to Martin Baccardax at martin.baccardax@barrons.com

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