The 2-year and 10-year U.S. Treasury yield spread is considered an important indicator by the market. During this round of Fed rate hikes, the 2-year and 10-year Treasury yields once inverted, which is generally seen as an early signal of a possible economic recession.
However, this tried-and-true signal has been repeatedly proven wrong in the past two years, as the U.S. economy has shown increasingly stable growth amidst widespread pessimism, and the &#34;recession&#34; hypothesis has yet to materialize. With the Fed's rate cuts looming, the yield spread between 2-year and 10-year Treasuries has continued to narrow and recently approached disappearance. What does the disappearance of the inversion signify? That is the question we hope to discuss today.
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Let's first look back at the trend of the 2-10 year Treasury yields. Since July 2022, the 10-year Treasury yield has been higher than the 2-year Treasury yield, and the yield curve inversion has persisted until late August 2024, spanning over two years.
With the fluctuations in U.S. inflation in this round, the yield curve inversion can be roughly divided into 4 stages. In the first stage, from July 2022 to July 2023, as U.S. inflation issues worsened, there was a widespread expectation of Fed rate hikes in the market, leading to a faster pace of increase in short-term rates compared to long-term rates, with the spread widening to -108 basis points.
In the second stage, from July 2023 to October 2023, U.S. inflation had been preliminarily alleviated, and there were basically no concerns about rate hikes in the market. However, the stickiness of inflation began to be recognized by the market, with long-term rates gradually rising, and the spread narrowed to -14 basis points during this period.
In the third stage, from November 2023 to July 2024, the U.S. inflation issue significantly improved, but inflation was further hindered by stickiness. Despite market expectations of rate cuts, the yield spread between long and short-term Treasuries remained relatively stable.
In the fourth stage, from July 2024 to the present, the market gradually confirmed that the Fed would start cutting rates, leading to a rapid decline in short-term Treasury yields. However, medium to long-term inflation issues persist, with the pace of decline in long-term Treasury yields relatively slow, and the spread basically disappearing by the end of August 2024.
Based on the above analysis, it can be seen that the financial market's perception of inflation largely determines the state of the yield curve. From the chart below, we can also see that the trend of the U.S. core CPI has been leading the trend of the 2-10 year Treasury yield spread in recent years.
However, when comparing the 2-10 year spread with GDPNow, we find that their correlation is not significant. Such comparisons also reveal that the &#34;unpredictability&#34; of inflation in recent years has become the core variable driving the yield curve.
From the perspective of monetary policy response, as inflation begins to rise, the market worries about an economic hard landing, leading to an inverted yield curve. But as inflation stabilizes, the yield curve gradually smooths out, and the inversion gradually disappears, indicating a significant reduction in market concerns about an economic recession
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Of course, for the market, the real issues that need to be addressed are the following two. The first is the shape of the future interest rate curve, especially whether term premiums will reappear. The key to answering this question lies in the judgment of the &#34;new steady state&#34; of the U.S. economy. That is to say, if the market broadly accepts a new inflation center, and the U.S. inflation rate remains near the new center, then rate cuts will be smoother, which will stabilize the level of the 2-year U.S. Treasury yield and investors will gradually price in new term premiums.
Currently, the market's view on the new nominal neutral interest rate in the U.S. is increasingly close to 3.5%. However, this rate level still needs more data and time to validate. Assuming this level holds, we can roughly consider the bottom of the 2-year U.S. Treasury yield to be around 3.5%. Based on historical experience, a term spread of 50 basis points should not be excessive, so the level of the 10-year U.S. Treasury yield may be at 4% or higher.
A more pressing issue for the market may be whether the interest rate curve can predict the economy. From past experience, the predictability of the interest rate curve for the economy is not ideal. If investors are to rebuild confidence in the interest rate curve, a new validation process will be necessary.
From this perspective, only when the interest rate curve significantly diverges from market consensus and is revalidated, can the predictive ability of the interest rate curve be reestablished. This process is likely to last for several years, meaning that in the foreseeable quarters, the interest rate curve will probably only have a mutually confirming relationship with short-term economic trends. At the same time, when inflation fluctuates, the interest rate curve may follow the trend of inflation, and only when inflation gradually stabilizes, can the interest rate curve better reflect the form and expectations of the economy. In other words, in the coming quarters, the market should not overly focus on the interest rate curve and term premiums.
Author: Zhou Hao S0880123060019, Sun Yingchao; Source: Guojun Overseas Macro Research; Original Title: &#34;U.S. Treasury Yields: The Disappearance of the 'Inversion'&#34;

Guotai Junan pointed out that the state of the US bond yield curve is influenced by inflation expectations. The inversion of the 2-year and 10-year US bond yields, which is usually seen as a signal of economic recession, has not led to a recession in the past two years. With the possibility of a rate cut by the Federal Reserve, the 2-10 year US bond yield spread has continued to narrow and is now close to disappearing. This change can be divided into four stages, reflecting fluctuations in US inflation and changes in market expectations

- The 2-year and 10-year U.S. Treasury yield spread is a key market indicator, with an inverted yield curve historically signaling a possible economic downturn. However, despite the curve inverting during the recent Fed rate hikes, the anticipated recession did not materialize, challenging the reliability of this signal. As the yield spread narrows with Fed rate cuts looming, the discussion shifts to the implications of the disappearing inversion, highlighting the market's evolving perception of inflation's impact on interest rate dynamics.
- Analyzing the trend of the 2-10 year Treasury yields reveals distinct phases linked to inflation dynamics and market expectations, influencing rate differentials. The evolving understanding of inflation's impact on interest rates underscores the complexity of predicting economic trends based on yield curve movements. Looking ahead, market focus shifts to predicting the future rate curve shape and the potential resurgence of term premiums, hinging on market consensus around a new inflation regime and the validation of nominal neutral interest rates.
- Market concerns extend to the predictive power of the yield curve on the economy, with historical data showing mixed predictability. Rebuilding investor confidence in the yield curve's forecasting ability necessitates a new validation process, likely spanning several years to realign market perceptions. In the interim, amidst inflation fluctuations, the yield curve may mirror short-term economic trends, emphasizing a cautious approach to interpreting its signals in the coming quarters.

US Treasury Yields: The Disappearance of "Inverted Yield Curve"