Strategists say the recent steepening of the US yield curve might be shortlived, warning it could invert again if the Federal Reserve fails to deliver enough interest rate cuts to soothe investors and stave off a slowdown.
Investors worry about an inversion of the yield curve - in which shorter-term rates are higher than longer-term ones - because of its power as an economic indicator. The curve has inverted before every recession of the last half century.
Fears of a downturn eased this month after a widely watched portion of the yield curved turned positive following months of inversion. Thursday's yield on the three-month Treasury bill was 8 basis points lower than that for the benchmark 10-year bond - after being as much as 51bp higher. The two-year Treasury yield was 16bp lower than that on the 10-year after inverting earlier.
Investors grew more optimistic as the US and China reached a tentative trade truce and Brexit negotiators moved closer to striking a deal with their EU counterparts over Britain's relationship with Europe. The Fed's announcement last week that it would buy $60bn of Treasury bills per month to help ease cash shortages in the overnight lending markets also helped pull short-term yields lower, analysts said.
But Scott Mather, a managing director at Pimco, said the forces that drove longer-dated yields above those on the short-end of the curve - the "mini-deal" with China, as he puts it, and the Brexit headlines - could reverse and the bond market could revert to where it was a few months ago.
Kathy Jones, chief fixed-income strategist at Charles Schwab, said much hinges on the Fed. "The signal from the inverted yield curve was that Fed policy was too tight," she said. She warned that the yield curve could re-invert if the Fed fails to deliver on the interest rate cut widely expected at the end of the month.
Traders are currently pricing in an 82 per cent probability the Fed will trim its benchmark policy rate another quarter-point at the end of the month - its third cut this year - with at least one more cut expected in 2020.
Splits have deepened since the summer between Fed officials over the future path of monetary policy, with Esther George, Kansas City Fed president, and Boston's Eric Rosengren pushing back on the need for cuts in the face of fresh US economic data that does not scream, "Oh, we need a big rate cut", according to Ms Jones.
Given this rift and the Fed's past reluctance to ease aggressively, Matthew Hornbach, the global head of interest rate strategy at Morgan Stanley, said the recent steepening of the yield curve should be viewed with "caution", as the Fed was unlikely to provide enough accommodation to appease investors.
"If the market is pricing in two more 25bp cuts over the next year, the Fed needs to deliver more than that," he said. "Nothing to me suggests the Fed is going to be more aggressive."
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