Higher and Tighter

The yield curve is a picture of how much interest the U.S. government has to pay to borrow money over different periods of time. These loans can vary from just a few months to several decades. Typically, the rates rise as the time horizon for repayment increases. But that is not always the case. As recently as mid-2022 through mid-2024, the relationship between 2-year treasury notes and 10-year treasury bonds was reversed. While this type of inversion is typically a harbinger of difficult economic conditions ahead, a recession never materialized.

Today that relationship is in its typical pattern (i.e., it cost the U.S. government more to borrow for 10 years than 2 years). But there have been some interesting movements recently. With inflation elevated, and the Federal Reserve increasing the overnight lending rate last week, the trend for interest rates has been higher as lenders demand more protection from the rising cost of living. While rates have been moving higher, the difference between interest paid on a 10-year bond and a 2-year note has been getting tighter. For example, the difference between the two at the start of this year was roughly 0.70 percentage point (4.17% - 3.47%); today, it is closer to just 0.21 percentage point (4.97% -4.76%).

The observation Atlas finds most interesting today is what is driving this change. As you may have noticed, the rate change for the 2-year note has been greater than the rate change of the 10-year bond (1.29 percentage points vs 0.8 percentage point). This relationship is called a bear flattener; it happens when shorter yields rise faster than longer yields.

While the change from the start of this year until now is not exactly a canary in the coal mine for the economy, it warrants further observation. It may indicate markets expect further restrictive monetary policy (following the upward 2-year rate trajectory) coupled with less optimism about the future (following the less-steep upward 10-year trajectory). The kicker, of course, is that they are both higher which reflects America’s inflationary circumstances today. For now, the message from the bond market seems to be “higher and tighter.” Borrowing costs continue to rise, but investors are not exactly convinced that stronger growth lies beyond the horizon.