Daily Spotlight: Slope Slowly Returning to Normal

Summary

The yield curve has been inverted for more than a year. But there have been changes over the past few months; specifically, the inversion isn’t so steep. This has implications for bond investors and the economic outlook. In April 2023, two-year Treasury note yields were about 100 basis points (bps) above 10-year yields. Now the gap is 15. There are a few reasons for this change, and they point toward an upcoming shift toward a normal upward-sloping curve in the next few quarters, in our view. First of all, U.S. economic trends have been positive. Fixed-income investors have moved away from fears of deflation and are again seeking a premium in yields versus inflation. That has lifted rates across the yield curve. Secondly, the Fed is finally in front of inflation. The central bank is building a cushion, or a gap, between fed funds and core PCE in order to push inflation back toward 2.0%. This is all well and good, but if the Fed’s gap is too wide for too long (we think a 170-bps gap is desirable, versus the current gap of 250-275 bps), the central bank risks tipping the economy into a recession, which is presumably what the inverted yield curve has been signaling. Fed Chairman Powell has explained to financial markets that he and his colleagues want to continue fighting stubborn inflation, so they are likely to keep short-term rates high for a period of time, which is

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