Treasury yield curve is un-inverting for what's shaping up to be the wrong reasons, SocGen says

One of the bond market's most reliable gauges of impending U.S. recessions is less deeply negative than it has been in months. The difference between 10- BX:TMUBMUSD10Y and 2-year Treasury yields BX:TMUBMUSD02Y narrowed to minus 47.5 basis points as of Thursday. The result is a less inverted or deeply negative 2s/10s spread relative to March and July, when it fell to below minus 100 basis points.Simply put, long-term Treasury yields are gradually catching up to where shorter-term ones are trading, though they're still lagging. Other spreads in the roughly $25 trillion Treasury market have either gone less negative or turned positive since the Federal Reserve's Sept. 20 policy update, as investors adjust to a higher-for-longer environment on rates. This week's selloff in long-term government debt, which pushed 10- and 30-year yields to multi-year highs, is helping the Treasury curve to re-steepen. Yield spreads typically invert, or go below zero, when there's greater pessimism about the economy. They un-invert or slope upward, with long-term rates trading above short-term ones, when the market tends to be more confident about the outlook. This time around, however, the difference between long- and short-term yields is shrinking as a reflection of rising financing costs that will hit everyone from home buyers to corporations, rather than less pessimism about the economic outlook or a reduced likelihood of a recession, according to Subadra Rajappa, head of U.S. rates strategy at Société Générale (FR:GLE) in New York. "This to me feels like it should lead to a tightening of financial conditions, with a sharp rise in real yields and commodity prices, even though the Fed has told us it isn't going to be hiking a lot more," she said via phone. "So the propagation of this pain is going to be through the markets, such as the mortgage market or credit market, where issuance is linked to benchmark yields like the 5- or 10-year rates. They are all going to start coming under pressure."The Treasury curve can re-steepen in two ways. One is when long-term yields are increasing at a faster pace than short-term rates, in what's known as a bear steepener -- which is what has recently happened. Bear refers to the sentiment behind the trade, which is to sell long-term Treasurys, and steepener describes the shape that the curve then takes.The other way is when short-term yields are falling by more than long-term yields on expectations of a recession or a policy interest rate cut by the Federal Reserve, or what's known as bull steepener. Bull refers to the buying of shorter-term Treasurys."We were very much on board with the view that the yield curve would steepen, but it's turning out to be an environment of bear steepening, not bull steepening," Rajappa said. The magnitude of the selloff in long-term Treasurys "is catching markets by surprise and the risk of a 10-year rate that could go above 4.5% had not been fully appreciated by the markets or myself. We need yields to move meaningfully higher before we see financial conditions tighten meaningfully from here, and it will take a bit longer for other assets to adjust to the new interest-rate regime." On Thursday, buyers of government debt reemerged during the New York afternoon, pushing yields lower on the day. Ten- and 30-year rates BX:TMUBMUSD30Y nonetheless remain near their highest levels since 2007 and 2011. Meanwhile, all three major U.S. stock indexes DJIA SPX COMP finished higher.

-Vivien Lou Chen

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09-28-23 1618ET

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