U.S. Inflation Rate Declines, Bringing Relief to Investors

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Wednesday’s U.S. June inflation data has provided welcome relief for investors, as it has eased the pressure on a deeply inverted Treasury yield curve, at least for now.

Narrowing the Gap

In New York on Wednesday morning, the 2-year rate TMUBMUSD02Y stood at 4.737%, trading approximately 85 basis points above the 10-year yield TMUBMUSD10Y, which was at 3.855%. This resulted in the smallest negative spread between the two yields observed in about a month. It is worth noting that only last week, the 2s10s spread exceeded minus 100 basis points. However, early Wednesday, before the release of the June consumer price index, the spread had narrowed further to minus 92.96 basis points.

Lowest Annual Headline Inflation Rate

Wednesday’s CPI data revealed that the annual headline inflation rate for June stood at 3%. This marks the lowest rate recorded since 2021, finally granting investors and traders a taste of the long-awaited decline in inflation.

Bond Market Sentiment Improves as Investors Cheer Report

As the stock investors celebrated a positive report, traders took aggressive actions in the U.S. government debt market, resulting in lower yields overall. Particularly, shorter-term rates like the 2-year yield experienced the most significant decrease. This drop in yields indicates that traders are now more likely to expect only one more quarter-of-a-percentage point rate hike by the Federal Reserve on July 26.

According to Bryce Doty, Senior Vice President and Senior Portfolio Manager at Sit Investment Associates in Minneapolis, the less negative 2s/10s spread reflects a shift towards a more positive sentiment. He describes it as a departure from a “sky-is-falling” type of messaging. Doty explains that this change bolsters confidence among investors since an inverted yield curve is usually viewed as a sign of disaster. As the negative signaling dissipates, it feels like a dark cloud disappearing.

It is worth noting that the 2s/10s spread is widely regarded as one of the bond market’s most reliable indicators of an approaching U.S. recession. However, it is not very accurate in pinpointing the exact start of such downturns. A negative spread typically signifies pessimism about the market outlook, while a positive spread reflects greater optimism. Since July of last year, the 2s/10s spread has consistently remained below zero.

Read: Bond-market recession gauge plunges further into triple digits below zero after reaching four-decade milestone

Impact of Negative Treasury Yield Spreads on Banks

Negative yield spreads in the Treasury market are having a significant impact on the business models of banks. Banks rely on borrowing money from customers’ deposits and lending it out over a long term. However, with lower inflation and interest rates, banks are facing challenges in maintaining a solid financial position. This is precisely why lower inflation and interest rates are crucial for banks at this moment.

According to Doty, who manages $9 billion in assets, lower yields are expected in the future. He recommends bond investors to increase their duration now and secure yields before they decline.

Declining Treasury Yields

As of Wednesday morning, there has been a general decline in rates, with 2- through 5-year Treasury yields leading the way. This decline in rates has implications for the overall market.

Market Performance

While Treasury yields are decreasing, the stock market is displaying positive trends. All three major U.S. stock indexes are experiencing gains. This suggests that despite the challenges faced by banks, other sectors of the market are performing well.

Impact on U.S. Dollar

The U.S. Dollar Index, which is closely tied to expectations regarding U.S. rates, has seen a decline of 1%. This indicates that investors are adjusting their expectations as Treasury yields continue to decrease.

Overall, the negative Treasury yield spreads have put pressure on banks’ business models. However, other sectors of the market are showing resilience and positive performance. As bond investors anticipate lower yields in the future, making strategic decisions to secure yields is essential.

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