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Chart of the Week - US yield curve disinverts as markets reprice bond risk

US 10-year Treasury yields rose as high as 4.88% in the first week of October, their highest level since 2007 and up by around 100 basis points relative to their level in July. The result has been a significant tightening of financial conditions in the US economy. The extent and speed of the move means negative economic consequences cannot be excluded (see turmoil in US banking in March 2023).   

It may be a desire to reign in the tightening in financial conditions that led Federal Reserve Bank of Dallas President Lorie Logan to note on 9 October that the surge in long-term Treasury yields may lessen the need for the Fed to raise its benchmark interest rate again. Her comments were followed by observations from Fed Vice Chair Philip Jefferson, who pointed out that the tightening of financial conditions and the sharp increase in long-term real yields were doing some of the hard work for the Fed. In his view, the “fabled sufficiently restrictive level” has been reached.

In the wake of these comments, and the latest events in the Middle East, US 10-year yields fell as much as 18 basis points to 4.62%, the biggest one-day decline since March. Two-year yields slipped 16 basis points to 4.92%.

The rise in US bond yields over the last two months has nonetheless brought about a comprehensive shift in longer-term rates. As the chart of the week shows, from an inversion of the US yield curve as recently as July of around 108  basis points (the extent to which 2-year yields exceeded 10-year yields), the difference fell to 32 basis points, the least inverted the yield curve has been in almost 12 months. 

This change in the yield curve has been driven by a ‘bear steepening’ of the yield curve. That is, yields of longer-dated bonds rising faster than those of short-dated US sovereign debt. This is partly explained by a rise in the term premium – the compensation investors require for the uncertainty inherent in holding a long bond. During the quantitative easing era the term premium was suppressed. Today, quantitative tightening, debt sustainability worries, and structural inflation risk arising from deglobalisation and the energy transition, for example, may be among the factors pushing the term premium higher.  Should this trend overshoot, it could inflict serious damage to risk assets and the economy. Hence perhaps, the efforts from Fed members to reign in the tightening in financial conditions.

Disclaimer

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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