Updated from 12:10 p.m. EST
A rally in Treasuries has pushed the yield curve to its most dramatic inversion since December 2000 -- and back then a similar setup preceded a recession.
Treasuries rose Wednesday after a government report on consumer prices tempered inflation fears and a two-year note auction was well-received. The benchmark 10-year note rose 10/32 in price to yield 4.53%, while the 30-year bond jumped 26/32 to yield 4.48%, a five-month low.
The five-year added 4/32 to yield 4.56%, and the two-year gained 2/32 to yield 4.67%. Prices and yields move in opposite directions.
According to Hugh Johnson, chairman of Johnson Illington Advisors, there are "reasons to worry that the
Federal Reserve will be seduced into raising short-term interest rates too high and will cause a downturn in the economy ... as the unintended result of their fight against inflation."
A $22 billion auction of two-year notes drew a yield of 4.689%, slightly higher than the 4.68% yield the notes had in preauction trading.
The bid-to-cover ratio was 2.24, meaning there were $2.24 worth of bids for every $1 of notes sold. The ratio was 2.11 in January. Indirect bidders, which include foreign central banks, took home 31.3% of the sale, compared with 25.6% last month.
Yields on the two-year, the note most sensitive to changes in the fed funds rate, are near their highest level in five years, propped up by expectations that the Fed will continue to raise rates in the first half of the year.
Next, traders will look to Thursday's weekly jobless claims for more inflation clues, particularly now that the Fed has said that further rate hikes will depend on economic data. The market will also be paying attention to the results of a $14 billion five-year note auction and remarks from Fed Vice Chairman Roger Ferguson, who's resigning from his post effective April 28.
Longer-dated maturities like the 10-year note and the 30-year bond typically yield more than shorter-dated notes because it's riskier to loan money for longer periods of time, even if it's Uncle Sam doing the borrowing.
An "inverted" yield curve implies that investors see more risk in the near term, and it has been a reliable leading indicator of economic slowdowns in the past.
However, Fed Chairman Ben Bernanke said during his congressional testimony last week that the inverted yield curve isn't a major concern, echoing comments made by his predecessor Alan Greenspan.
Bernanke argued that inversions have predicted recessions when interest rates are generally high, since this tends to restrain activity. However, he said short-term rates are still in a "fairly normal range" and that long-term rates are "low, historically speaking," in part because of tremendous demand from foreign investors and pension funds for longer maturity debt.
Fed funds futures contracts show that traders are pricing in 98% odds that the central bank will raise the overnight lending rate from 4.50% to 4.75% in March. Traders see a 74% chance that policymakers will hike rates again in May. The Fed has raised rates at 14 straight meetings going back to June 2004.
Even though it looks like the market has accepted the possibility of more rate hikes, Johnsons says, "When I crunch the numbers, there is a good chance that at 4.75% or 5%, the Fed will have raised rates too high."
For many bond traders, the big news of the day centered around the government's latest report on inflation at the consumer level. The consumer price index for January showed a gain of 0.7%, a touch higher than expectations for a 0.5% gain. The all-important core CPI, which excludes food and energy prices, rose 0.2%, in line with Wall Street's estimates. The core rate hasn't posted a monthly gain of more than 0.2% since March 2005.
"The core rate is pretty much in line and it's not really showing any signs of accelerating," says Peter Cardillo, chief market analyst with SW Bach & Co. "There are some pressures with higher energy costs, but it doesn't look like the market is really worried."
Cardillo says that if the housing market were to slow down sharply, that could lead to a more troubling drop in economic growth. Bernanke doesn't seem overly concerned so far, saying last week that the housing market will slow to a sustainable, healthy level, but he doesn't expect to see an acute decline in the sector.
So Many Homes
Underscoring Bernanke's point, the Mortgage Bankers Association index increased by 0.8% last week to 578.5 from 574.1, while mortgage applications saw their first bump higher in four weeks.
Cardillo said the current yield curve inversion was more likely due to a "flight to quality." The market has faith that the Fed will keep inflation in check, making longer-dated investments less risky, he says.
Drew Matus, senior U.S. economist at Lehman Brothers, says the shape of the yield curve is also attributable to supply and demand imbalances in the Treasury market, with an oversupply at the short end and a paucity of bonds on the long end.
Additionally, Matus says that most observers believe higher oil prices, which add to inflationary pressures, aren't sustainable forever.
"And if they do stay high, the Fed will clamp down on growth and contain inflation ... and then there will be less need for yield," he says.
Former Fed chief Greenspan was scheduled to speak Wednesday with ABN Amro clients, but his comments didn't have much impact on the market. Greenspan led the U.S. central bank for more than 18 years before handing the reins to Bernanke at the beginning of February.
Treasuries fell on Feb. 8 after Greenspan, who had vacated his post just days earlier, told Lehman Brothers clients that the economy was going strong and suggested that the Fed may have to remain hawkish on rates.