US Treasury yield curve flattens to near 2-year lows on hawkish Fed

The US Treasury yield curve flattened to within touching distance of a two-year low on Thursday after the Federal Reserve raised interest rates as widely expected but trimmed its growth forecasts for the remainder of the year.

The spread between two-year and 10-year notes fell below 20 basis points (bps), from around 30 bps before the Fed statement and holding just above a March 2020 low of 18.5 bps hit last week.

That was mainly driven by a bigger and durable rise in shorter-dated yields after the Fed indicated it would act aggressively to stamp out inflation. While longer-dated yields also rose, they gave up a large chunk of their rise in Asian trading.

“What was surprising was that the Fed took down GDP forecasts more than what perhaps the ECB did, signalling that growth would struggle, and we think the curve flattening trend has further legs to run,” said Kaspar Hense, a portfolio manager at Bluebay Asset Management who unwound his short duration trade after the Fed decision.

On an outright basis, ten-year US Treasury yields were at 2.13% in London trading after rising to a May 2019 high of 2.25% on Wednesday.

Policymakers raised interest rates for the first time since 2018 on Wednesday but marked down their gross domestic product growth estimate for 2022 to 2.8%, from the 4% projected in December, as they began to analyse the new risks facing the global economy.

The yield gap between five-year notes and 30-year bonds held at 25 basis points, the smallest since October 2018.

Fed funds futures traders are now pricing for the Fed’s benchmark overnight interest rate to be 1.93% by the end of this year, up from around 1.82% on Wednesday before the decision.

Jim Reid, a strategist at Deutsche Bank noted that on average it took around three years from the first Fed hike for the economy to tip into recession though all but one of those recessions occurred within 37 months when the 2s10s curve inverted before the hiking cycle ended.

Parts of the yield curve such as the spread between 10-year and five-year US debt were already in danger of inverting with the gap holding at 1.5 bps on Thursday.

A section of the US yield curve, notably the gap between 10 and 3 year bond yields fell briefly below 0 for the first time since March 2020.