The yield gap between the two-year note and the 10-year note briefly touched its widest levels in more than a year on Thursday, reflecting the bond market’s growing optimism that an economic downturn will be averted.
The widely-watched gauge of the yield curve’s slope steepened to as much as 31 basis points, its most positive since last October, after the 10-year Treasury note yield TMUBMUSD10Y, +0.10% spiked to a four-month high of 1.95% on Thursday. The spread later ended at 29 basis points by the close of Thursday.
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“Coinciding with growing expectations of a truce in the US-China trade war — confirmed with the interim deal announced late last week — and with a bottoming out of world trade, this has pushed long-end yields higher and thus steepened the yield curve,” wrote Shweta Singh, an analyst at TS Lombard, in a Wednesday note.
Along with the Federal Reserve’s pause, the U.S.-China trade deal has helped diminish concerns that a global slowdown would spill over into the domestic economy and push it toward a painful recession. Those worries had led to extreme bullish positioning in August, when the rally in long-term government bonds helped to invert the yield curve, seen as a prelude to an economic downturn.
Another sign that bond investors believe the U.S. economy will continue to truck on is the recovery in inflation expectations, albeit from depressed levels. The five-year breakeven inflation rate traded at 1.70% on Thursday, from a low of 1.25% in early October, Tradeweb data showed. The breakeven rate is the market-based forecast of price levels over the next five years as derived from trading in the five-year Treasury inflation protection securities (TIPS).
Yet with inflation expectations still capped, the steepening curve may simply indicate that the U.S. is looking at steady but boring growth, and not the beginning of a full-blown reflation trade.
“With inflation low and the Fed on hold, what does [the steeper curve] mean? Right now, it likely means that the fixed income market is fairly priced for 2% growth and less than 2% inflation,” wrote Kevin Giddis, chief fixed income strategist at Raymond James.