By Yasin Ebrahim
Investing.com – Bond traders have earned a reputation as the 'smartest traders in the room' but their latest flurry of bets that have flattened the Treasury yield curve -- pointing to economic doom -- has left many scratching their heads.
The 10-year fell 7 basis points, to 1.54%, and the 2-year climbed 6 basis points, to 0.50%, earlier this week, resulting in a flattening in the yield curve to 104 basis points from 116 basis points. That's the flattest since late August, according to Reuters.
As the frenzied battle in the yield curve intensifies, the front-end of the curve is coming out on top against the long-end, causing the curve to flatten further.
This flattening could be explained away by aggressive bets that Fed rate hikes, which impact the front-end of the curve, will emerge a lot sooner than many expect, potentially triggering a significant slowdown or recession.
“The bond market is basically saying that the Fed is going to hike rates, but because the fundamentals of the economy are weak, they may be risking a recession,” Zwei Ren, managing director and portfolio manager at Penn Mutual Asset Management, told Investing.com in a recent interview.
The latest rate-hike odds suggest that the Fed could lift rates as early as June next year, according to Investing.com’s Fed Rate Monitor Tool. The aggressive bets come in the wake of increasing worries about the pace of inflation.
While the jury is still out on whether the Fed is losing its grip on inflation, any doubt over the strength of the U.S. consumer has been washed away as the latest wave of earnings showed spending remains healthy.
This strength in consumer spending, which forms two-thirds of economic growth, will soon power up rates on the long end of the curve.
“Eventually, the market will realize it has been too pessimistic about the long-term growth in the U.S., and we should see increase in rates in the long-end of the curve,” Ren added.
“Demand is extremely strong in the U.S. […] this kind of momentum is going to push the economy,” according to Ren. “I see zero risk of a recession in the next 12-to-18 months.”
The strength in demand, however, has come up against a proverbial brick wall amid supply-chain bottlenecks that has driven up costs, leading to explosive inflation.
While supply-chain bottlenecks are largely expected to subside, wage pressures hold sway on whether inflation will prove transitory or not. Against the backdrop of rising wages, the Fed is betting that eventually more people will enter employment, propping up the labor participation rate and forcing wage pressures to ease.
Investors won’t have long to wait for clues on whether the Fed’s transitory inflation narrative is wearing thin.
“The long-awaited tapering announcement is almost certainly going to be delivered [next week],” Morgan Stanley (NYSE:MS) said. “The bigger question is whether the FOMC will keep the ‘transitory’ language,” it added.
“We are leaning toward a yes, because removing it could unhinge the front end of the curve, and in turn cause an unwanted tightening of financial conditions.”