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The bond market is sending a message. Investors should listen.

The bond market is sending a message.  Investors should listen.


In the stock market, everything seems to be going in reasonable order, with one stock following another, even with occasional setbacks. But the bond market is sending a different signal.

This week, the yield on short-term Treasury debt rose faster than that on longer-term Treasury debt. At market close Friday, two-year Treasuries yielded 47.9 basis points, or hundredths of a percentage point, more than 10-year Treasury debt. That compares to a gap of 45.9 basis points on Thursday and is the widest gap so far this year.

Such a gap, or inversion, where investors are paid more for holding short-term government debt than for longer-term securities, tends to suggest tougher economic conditions. The yield curve, which represents the yields on debt maturing at different times, has been inverted for the longest period in U.S. history, and there is no sign that this trend is coming to an end.

On the surface, this makes sense. The short end of the curve is more influenced by the Federal Reserve's monetary policy actions and comments from central bank officials this week ended any expectations of a rate cut this summer. Expectations that short-term interest rates will remain higher as the Fed continues to fight inflation, along with strong unemployment claims data, have brought the 2-year yield dangerously close of the 5% level.

Bond markets are poised for higher yields. “10 years is not there,” wrote Andrew Brenner, head of international fixed income at NatAlliance Securities, shortly before heading to the beach for a walk on Friday.

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As Wall Street celebrates the Memorial Day break, at least two stories are circulating about why the 10-year yield, which responds to economic growth, has lagged behind the two-year yield, which has caused an even deeper inversion of the curve.

Brenner says investors at both ends of the curve seem to be focused on different things. The long end appears to be paying attention to a weakening economic scenario, but the short end is under fire from the Fed and some recent mixed numbers, he wrote.

Expectations of a slowing economy, which would make a rate cut more likely, are one reason why investors might buy longer-term debt now, securing the current relatively high yields.

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The federal government's record is the other factor. The Federal Open Market Committee decided that starting in June, it would let $25 billion of its bond portfolio mature monthly without using that money to buy more debt, up from $60 billion currently.

The net effect is that more money from the Fed will flow into the Treasury market, which can drive up prices and lower yields. These expected purchases could already weigh on longer-term returns. The New York Fed's website shows that 34% of federal Treasury holdings mature in 10 years or more, the highest allocation to any maturity group.

Investors should be wary of Treasury auctions next week. Barry Knapp, managing partner of Ironsides Macronomics, says sales could put pressure on the back end, leading to higher yield and lower prices. This could reduce the yield curve inversion, if short-term yields hold or decline.

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Wall Street, for now, can enjoy the sunny weather and the long weekend. Till Tuesday.

Write to Karishma Vanjani at [email protected].




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