Bond Brief: Wider Deficits, Deeper Inversion

The spread between two- and 10-year note yields widens to 10 basis points.
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Updated from 10:49 a.m. EST

Treasuries sank Friday amid fears of rate hikes and uncertainty ahead of Ben Bernanke's first appearance as

Federal Reserve

chairman, leaving the yield curve deeply inverted.

Rounding out an active week of corporate bond news,

Merrill Lynch

(MER)

said it sold $1.75 billion in debt, and

Cisco

(CSCO) - Get Report

announced that it will

issue $5.5 billion of bonds.

The corporate debt market saw $16 billion in new debt this week, led by

Verizon

(VZ) - Get Report

and

Linen 'n Things

(LIN) - Get Report

, up from $7.5 billion the previous week.

The benchmark 10-year Treasury ended the day down 10/32 of a point to yield 4.58%, after yielding as little as 4.50% earlier in the session, while the 30-year bond sank 25/32 to yield 4.55%.

The five-year note lost 6/32 to yield 4.58%, and the two-year edged lower 2/32 to yield 4.68%, 10 basis points more than the 10-year yield and 13 basis points more than the 30-year.

When yields on short-maturity debt rise higher than those on the long end, "inverting" the curve, it could mean that investors see more risk in the near term, a perception that has historically preceded an economic slowdown or recession.

An inversion in the spread between 10-year and three-month yields is the spread that the

Federal Reserve

is most concerned with, according to Miller Tabak. The brokerage firm says that once the inversion between these yields hits the midteens, in terms of basis points, odds of a recession within four quarters jumps to 30%. The three-month bill was recently yielding 4.53%.

When yields between the two- and 10-year notes inverted in 2000, an event that did precede a recession, it was by a little more than 50 basis points, according to Cantor Fitzgerald.

"What we see developing is a slower second half," David Ader, chief bond strategist at RBS Greenwich Capital writes in a research note. "The magnitude of that is in good measure dependent on a slowing in housing, the impact of the Fed's 350-400 basis points worth of tightening, high energy prices and a tapped out indebted consumer. We see signs that these drags are underway."

However, Ader doesn't think the economy is heading for catastrophe. He predicts that the curve will soon flatten out, and that yields on the short end are moving higher as the market prices in more fed funds rate hikes.

"Market forces are determining long rates, and policymakers are determining short rates," says Jim Glassman, chief economist at JP Morgan. "We're not really in a recession state, though people are still skeptical of the recovery. Companies have a lot of profits and a lot of cash.

"For all the bearishness out there due to the new Fed chief (Ben Bernanke), new supply hitting the market, rumors of very strong first-quarter growth and the phantom inflation problem, despite it all, long rates continue to stay in the low range they've been in for the last three years," says Glassman. "This is further confirmation that low inflation worldwide and global trade are holding rates here."

In the meantime, he adds, the front end is waiting for Bernanke to say what will happen to the overnight lending rate.

The futures market has priced in near certain odds that the fed funds rate will hit 4.75% in March and 80% odds that the Fed will push it up to 5.0% by June.

Next week is packed with a mix of data and events that could move the market, including testimony from Bernanke before the House Financial Services Committee and the Senate Banking Committee, his first public comments since taking the Fed reins from Alan Greenspan.

Until his testimony, the market will scour economic reports for signs of inflation now that central bank policymakers have said future rate hikes will be entirely data dependent.