Curve Flattens Ahead of Key Inflation Data Tomorrow

For today, at least, investors aren't worried about rising inflation.
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The long Treasury bond moved a bit higher in price and lower in yield today in a low-volume session whose most interesting development was a flattening of the yield curve to a level not seen in nearly a year.

The yield curve measures the difference between short and long interest rates. When it is increasing, or steepening, short-maturity instruments are outperforming, usually indicating that investors are concerned about too-fast growth and higher inflation. By contrast, a flattening curve means that long-maturity instruments are outperforming, which tells you that there's little concern about inflation getting out of hand.

Lately, a couple of special factors are helping to flatten the curve, as measured by the difference in yield between the benchmark 30-year Treasury and the two-year Treasury note. That difference, which collapsed to 40 basis points on Friday from 51 on Thursday, shrank further to 37 basis points today, its smallest since Aug. 26, 1998.

The steep drop on Friday was largely a function of the fact that the Treasury issued a new 30-year bond on Thursday. The new bond, which went into the yield curve calculation on Friday, has a lower yield than its predecessor in large part because it is the last new bond that will be issued before Y2K. For investors who want to own the latest, most liquid bond when the year draws to a close, this is it.

Also helping the bond outperform is the fact that the Treasury this past week announced that from now on it will issue a new bond only twice a year, down from three times. That more favorable supply picture is giving the 30-year sector a boost.

But the curve certainly wouldn't be flattening if the

Fed

weren't in rate-hiking mode, since short-term yields closely follow the rates the Fed sets. After raising the Fed Funds rate, the key short-term interest rate, to 5% from 4.75% in June, the Fed is widely expected to hike again next Tuesday, to 5.25%. Beyond that, the bond market is divided about what is likely to happen, with a significant minority arguing that a third hike is in the cards.

Regardless, until bond investors are convinced that the Fed is done hiking, short-maturity yields can't go anywhere but up. And since a restrictive monetary policy should control inflation, the inflation premium that long-term investors demand can shrink, lowering long-term yields relative to short-term and flattening the yield curve.

The 30-year issue added 3/32 today to 100 14/32, trimming its yield a basis point to 6.09%, while the two-year note lost 1/32, lifting its yield 4 basis points to 5.74%.

Beyond the action in the curve and this morning's publication by bond guru Bill Gross of a highly bullish view on interest rates, there was little market activity of note ahead of the release tomorrow morning of the July

Consumer Price Index

. (See the early

Bond Focus for the details on Gross' piece, which argues that interest rates are at or near the highest levels that will be seen this year, marking a buying opportunity.) Volume was light even for a Monday (the bulk of the trading each week usually takes place on Tuesday, Wednesday and Thursday), with tracker

GovPX

seeing just $28.6 billion change hands, 13.2% below average for a Monday in the past month.

The CPI, which measures inflation more broadly than any other government statistic, is expected to rise 0.3% overall and 0.2% at its core, which excludes volatile food and energy prices. On Friday, the July

Producer Price Index

printed weaker-than-expected, but there is little overlap between the two measures. The PPI measures inflation at the wholesale level, and it doesn't include any services prices.

An in-line report will support the view that the Fed is unlikely to hike rates more than once more before the year is out. But

Warburg Dillon Read

Treasury market strategist Mark Mahoney said "if the CPI is on the high side it could take the whole market down to new lows without any problem at all." He defined a high-side CPI as one with a core-rate increase of 0.3% or more.

"As long as it's considered preemptive, it's going to be limited," Mahoney said of the Fed's tinkerings. "If it appears they're going to have to do more, then market valuations change a lot."