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Bond Report: Treasury yield curve flattens further as Fed’s favorite inflation gauge stays well above 2% and consumer sentiment remains low

The spread between 5-year and 30- year Treasury yields flattened further Friday to levels not seen since March 2020, with the Federal Reserve’s favored inflation gauge holding well above the central bank’s 2% target but U.S. consumer sentiment still near the lowest levels since the pandemic began.

What are yields doing?

The yield on the 10-year Treasury note
TMUBMUSD10Y,
1.562%

fell 1.3 basis points to 1.555%, compared with 1.568% at 3 p.m. Eastern on Thursday. It’s up by 2.7 basis points for the month and had the largest three-month gain since April, based on 3 p.m. yields, according to Dow Jones Market Data.

The 2-year Treasury note yield
TMUBMUSD02Y,
0.501%

fell less than one basis point to 0.491%, compared with 0.499% Thursday afternoon. It has risen 20 basis points in October, its largest monthly rise since April 2018.

The 30-year Treasury bond yield
TMUBMUSD30Y,
1.947%

was down 2.1 basis points at 1.941% versus 1.962% on Thursday. It has dropped 15 basis points this month, for the largest one-month decline since July.

What’s driving the market?

The spread between the 5-year and 30- year Treasury yields narrowed further on Friday, suggesting traders remain concerned about the economic outlook. The spread narrowed to 75.2 basis points as of 3 p.m. New York time on Friday, the flattest level since March 2020, according to Tradeweb.

Similar yield curves also flattened in the U.K., Germany, Italy, and France, as markets priced in more monetary policy tightening despite an uncertain global economic growth outlook. Meanwhile, rates on overnight-indexed swaps have risen in recent weeks for the U.S., U.K., and Australia, while those of Europe and Japan turned less negative, according to Tradeweb. OIS rates are another sign of markets pricing in further tightening by central banks.

U.S. data released Friday showed that the Federal Reserve’s favored inflation gauge held well above the central bank’s 2% target. The 12-month increase in the PCE index rose to 4.4% in September from 4.2% in the prior month. And the core PCE rate that strips out food and energy held steady at 3.6% on an annual basis.

Consumer sentiment remained near the lowest levels of the pandemic, based on University of Michigan data, and household expectations for inflation over the next year hit a 13-year high.

Personal income slumped 1% in September, versus the 0.4% decline that economists were looking for, as pandemic-related assistance programs wound down. However, consumer spending rose 0.6% in September as Americans dipped into their savings, a gain that was in line with forecasts of economists surveyed by The Wall Street Journal.

Amid end-of-month position squaring on Friday, investors are awaiting next week’s Federal Reserve policy meeting, which is widely expected to see policy makers unveil plans to begin scaling back monthly bond purchases.

Rising yields at the short end of the curve are tied to expectations that central banks across the world will be more aggressive than previously expected to address inflationary pressures. Meanwhile, yields at the long end of the curve have either fallen or risen at a less aggressive pace than short-end rates have.

Read: Bond market yield curve flattening continues as U.S. growth slows, while ECB’s Lagarde pushes back on rate-hike expectations

In a potentially troubling sign for the rest of the Treasury curve, an inversion emerged in the spreads between 2- and 3-month T-bill rates, in addition to an already inverted spread between 20- and 30-year Treasury yields — meaning the 2-month rate was higher than the 3-month rate and 20-year rate was above the 30-year rate
TMUBMUSD30Y,
1.947%
.

What are analysts saying?

“The transition toward a more hawkish global central banking stance has been the unifying theme across fixed income markets,” BMO Capital Markets strategists Ian Lyngen and Ben Jeffery wrote in a note. “While the FOMC is poised to announce tapering next week, the more relevant debate in the Treasury market is how quickly the Fed will deliver on the ambitious liftoff hikes already priced into the futures market. Our take remains that the better-than-even odds of the June liftoff are far overstated and the Fed will err in favor of a longer window between the end of bond buying and the first hike.”

Signs of monetary tightness are emerging around the world, with U.S. dollar liquidity “falling hard this morning,” according to Colin Stewart, head of Americas for Quant Insight. “Japanese and European banks and institutions are feeling incremental tightness in the ability to access USD funding.”

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