What happens to 2Y, 10Y and 30Y yields next depends on numerous factors, including:

• Inflation: will it continue to recede or not?
• Growth: an economic downturn could oblige the central bank to lower short-term rates, potentially steepening the yield curve.
• Financial stability: any hints of instability in the banking system could cause a steepening of the yield curve.
• Quantitative tightening (QT)/quantitative easing (QE): will the Fed dial back on QT, or possibly move back to QE?
• Budget deficits: continued large deficits could put upward pressure on longer-term yields.

Since peaking at 6.6% in September 2022, U.S. core consumer price index (CPI) has moderated to 3.9% year on year (YoY). That’s still roughly twice the pace of core inflation between 1994 and 2020, and much too high for the Fed’s liking. When the most recent inflation numbers came out on February 13 showing a 0.2% upside surprise versus consensus, yields rose across the curve, but 2Y yields rose more than the others on the premise that higher-than-expected inflation would delay rate cuts.

Those who expect inflation to continue falling often point out that the reason why it remains elevated can be boiled down to one word: rent. Rental costs continue to rise at 6.2% year on year. Since shelter costs account for nearly one-third of CPI, the fast pace of rental inflation masks disinflation elsewhere in the economy. Outside of rent, CPI is rising at around 2% per year.

Even so, there are many reasons to fear that core inflation may not return to 2%. Tight labor markets, increased protectionism and economic nationalism, rising geopolitical tensions, and increased spending on the military and infrastructure could set the economy on the course to structurally higher inflation.

A look back at the late 1960s and early 1970s offers a worrying point of comparison. Core inflation rose from 1965 to 1969 before receding between 1970 and 1972 only to surge higher in two successive waves later in the 1970s. Just because inflation has receded from its 2022 peak doesn’t mean it will continue to go back to the 1994-2020 norm of 2% and stay there. Higher inflation might push 2Y bond yields up more than 10Ys and 30Ys by obliging the Fed to keep rates higher for longer (Figure 2). 

Thus far, the U.S. economy has continued to grow at a solid clip despite the Fed’s 525 basis points (bps) of rate hikes. That said, the Fed presumably only finished hiking rates seven months ago. Moreover, the U.S. yield curve remains steeply inverted with Fed funds rates over 100 bps above 10Y U.S. Treasury yields.

Over the past 50 years, an inverted U.S. yield curve has often been a harbinger of recessions. Yield curve inversions in 1979 and 1981 were followed by recessions in 1980 and 1982. An inverted yield curve in 1989 was followed by a recession in 1990-91. The yield curve inversion of 1999 and 2000 was followed by the tech wreck recession in 2001. A yield curve inversion in 2006 and 2007 preceded the global financial crisis in 2008 and 2009. Typically, the economy grew during the periods of yield curve inversion only to fall into recession on average two to two-and-a-half years after the yield curve inversion began (Figures 3 and 4).

This time around the yield curve inversion began in late 2022 and remains steeply inverted as of February 2024. If the U.S. were to experience a downturn later this year or in 2025, the Fed would likely respond by cutting interest rates substantially to the relative benefit of 2Y Treasury yields. During the past three recessions (not counting COVID-19 lockdowns), the Fed cut rates by 500 bps or more each time. 

Sometimes the Fed cuts rates even when the economy isn’t in a recession. This happened in 1998 after Russia defaulted on its debt, resulting in the collapse of Long-Term Capital Management (LTCM), an over-leveraged U.S. hedge fund. The Fed cut rates by 75 bps, causing a steeper decline in 2Y yields than in 10Y or 30Y yields. If problems related to rising defaults on credit card debt or commercial property cause problems for the banking sector, the Fed might ease policy even if the economy is still growing.

When Fed funds rates got stuck near zero in 2009 and again in 2020, the Fed began expanding its balance sheet to lower the level of bond yields further out the yield curve. Since 2022, the Fed has been doing the opposite, shrinking its balance sheet at a pace of $95 billion per month by allowing its reserves to roll into maturity without reinvesting the proceeds in the U.S. Treasury market.

This isn’t the Fed’s first attempt at QT. In late 2017 and in 2018, the Fed attempted balance sheet shrinkage, which lasted until December 2018, when there were problems in the U.S. Treasury repo market. This led the Fed to reverse course and expand its balance sheet again in early 2019. Indeed, during the current QT cycle the Fed expanded its balance sheet in response to the collapse of Silicon Valley Bank in 2023, temporarily creating over $100 billion in liquidity in the midst of a tightening cycle. Moving from QT back to QE can flatten the yield curve by creating a new source of buying for longer-dated U.S. Treasuries (Figure 5).

The U.S. continues to run a budget deficit of around 6.5% of GDP (Figure 6). Large deficits imply tremendous Treasury issuance. In Q1 2024 alone the U.S. Treasury aims to issue $760 billion of debt. Absent Fed buying in the form of QE, such large amounts of issuance may put upward pressure on long-term bond yields. If the U.S. experiences a recession, the deficits could expand much more as tax revenues decline and automatic stabilizers such as unemployment increase. In the aftermath of the 2008 global financial crisis, 2Y bond yields fell from 5% to around 1% while longer-term bond yields stayed up at 4-5% amid increasing debt issuance. It wasn’t until the Fed started engaging in an open-ended QE program that long-term yields began falling.