A dramatic flattening in key parts of the U.S. Treasury yield curve is reflecting worries that the Federal Reserve has been too slow to raise interest rates and will now risk causing a recession by tightening monetary policy too aggressively.
The gap between yields on two-year and 10-year U.S. government debt is the smallest since July 2020 and compressed sharply after the latest inflation was released Feb. 10.
Investors watch the yield curve for insight into the U.S. economy. An inverted curve, where rates on short-term government debt exceed those on longer-term debt, has reliably predicted past recessions.
In this case, investors believe the flattening yield curve reflects worries that the Fed has already let inflation get out of control by being slow off the mark in raising interest rates and risks hurting growth as it hurries to catch up.
"On the one hand, the market is saying this is what the Fed is going to be doing, and on the other side it's saying 'oh by the way, it's going to be a mistake,'" said Tom Fitzpatrick, chief technical strategist at Citi.
Investors are now pricing in around 175 basis points of interest rate increases by next February and a 62% chance the Fed will raise rates 50 basis points at its March meeting. A rate hike of at least 25 basis points in March is fully priced in.
"The bond market is saying that we're in a bit of a boom here and the Fed has a lot of work to do," said Padhraic Garvey, regional head of research, Americas, at ING.
The two-year, 10-year yield curve is the most closely watched as a recession indicator, with an economic downturn seen as likely six months to two years after this part inverts.