Treasury market flashes sign of growing stagflation risks

By Vivien Lou Chen

A worrisome trading pattern in the roughly $30 trillion Treasury market points to concerns about the economy and inflation

A hot reading of the producer-price index on Wednesday is leading to greater worries in the bond market about higher inflation and weakening economic growth.

A sharp increase in U.S. wholesale prices added to warning signs from the bond market on Wednesday about the growing risks of stagflation in the economy.

Stagflation, an unwelcome mix of higher inflation and weakening economic growth, is one of the worst possible outcomes for investors because it can shrink corporate profits, cause both stock and bond returns to fall, and stifle policy options for the Federal Reserve.

The producer-price index for February was released early Wednesday, reinforcing market participants' concerns by showing the cost of wholesale goods and services climbed for the third month in a row. Wholesale inflation jumped 0.7% for the biggest increase in seven months, while the monthly core figure rose a sharp 0.5%.

In response, the 2-year Treasury yield BX:TMUBMUSD02Y climbed 7.2 basis points to 3.74%, one of the highest levels since last August, as U.S. government debt sold off and stocks DJIA SPX COMP finished sharply lower on Wednesday.Also on Wednesday, Fed officials left their main interest-rate target at between 3.5% and 3.75% and acknowledged developments in the Middle East. Chair Jerome Powell told reporters that policymakers have discussed whether their next move should be a rate hike, but don't see that as a base-case scenario yet. Powell also indicated that he wouldn't use the term "stagflation" to describe the current environment.

The $30.6 trillion Treasury market began selling off earlier in the day on rising oil prices. Brent crude futures (BRN00), the global oil benchmark, rose above $109 a barrel after one of Iran's key natural-gas fields was hit in U.S. and Israeli airstrikes. The military conflict, which began on Feb. 28, threatens to stoke a resurgence of U.S. inflation.

Wednesday's bond-market selloff then picked up after the producer-price index for February landed Wednesday morning. "The upside surprise to both headline and core February PPI further raises stagflation concerns and bolsters the case for the Fed to stay on hold this year," said Subadra Rajappa, head of research at Société Générale in New York.

The 2-year yield led the rise in Treasury yields Wednesday, while the 10-year rate BX:TMUBMUSD10Y lagged - producing what's known as a bear-flattening pattern. Such a dynamic occurs when the rise in short-term yields occurs at a faster pace than in long-term rates, shrinking the spread between the two. It usually indicates the likelihood of tighter-than-expected Fed policy and the potential for either slowing or contracting economic growth.

The spread between 2-year and 10-year yields narrowed to 51.5 basis points, from roughly 53 basis points on Tuesday. The gap had been as wide as 74 basis points in early February.

The flattening "is clearly an indication of the market's more guarded outlook for Fed policy, and raises the concern of stagflation," said Gary Schlossberg, a global strategist at Wells Fargo Investment Institute in San Francisco. "But we are of the view that this will not be the stagflation of the 1970s. The risk of elevated inflation and weak economic growth has gone up, but we believe any such combination will be short-lived."

Tom Hainlin, a Minneapolis-based national investment strategist at U.S. Bank Asset Management Group, said he does not think the U.S. is entering a stagflationary period yet. "We think we are still in an environment where events in the Middle East can unfold and reverse pretty quickly, and that we are in something more like a classic energy shock," he said in a phone interview. "Until higher oil prices bleed over into higher inflation expectations, to us, it hasn't translated into a stagflation environment yet."

-Vivien Lou Chen

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03-18-26 1633ET