Let's see if the market can handle it. 

U.S. Treasury yields continued to climb in early Friday trading, taking benchmark 10-year notes to a six week high and closer to the 3% threshold, as the cost of funding last year's Republican-led tax cuts continues to impact the world's biggest bond market. 

Despite two sets of weaker-than-expected inflation readings this week, including the first fall in factory gate price rises for 18 months and the slowing of headline consumer inflation to 2.7% over the month of August, bond yields have been rising for most of the past month, taking benchmark 10-year yields to today's six-week high of 2.987%.

Much of the moves, which correspond to falling bond prices in the $15 trillion market, are linked to the increasing size of bond auctions from the Treasury, which is tasked with raising cash to fund the government's ballooning deficit triggered by last year's $1.5 trillion tax reform bill. The ongoing reduction of the Federal Reserve's balance sheet, which includes $2.13 trillion in Treasury bonds across all maturities, will also weigh on the market in the coming months. 

"The US dollar is turning broadly lower, likely due more to the shift in sentiment in emerging markets and risk appetite rather than due to the weaker-than-expected US CPI data and any spin from the European Central Bank meeting," said Saxo Bank's chief currency strategist, John Hardy. "Plenty of other evidence points to ongoing inflationary pressure in the US and the US Treasury market reaction was swiftly reversed later in the day, so we can safely say that this looks like a blip."

The U.S. dollar index, which tracks the greenback against a basket of six global peer currencies, was marked a few ticks lower at 94.49 in overnight trading, but has fall around 1% this week amid the softer inflation data and an improving risk sentiment in emerging markets after Turkey's central bank aggressively raised interest rates -- to 24% -- in order to defend in plunging lira.

It's also taken some of the steam out of investor expectations for Federal Reserve rate hikes, and although the CME Group's FedWatch tool is still suggesting a 77% chance of a December move, that's down from just over 80% on Wednesday prior to the PPI release. 

A hike at the Fed's September 26th meeting, however, is all but assured, with a 98% probability currently priced-in for a move that would take the central bank's target rate to between 2% and 2.25%.

Those bets, alongside the broader strength of the U.S. economy, have taken the difference between long and short-term bond yields, often referred to as the "curve" to just 0.218%.  

The US 2-year Treasury #yield has risen sevenfold to 2.76% over the last five years. For comparison the German 2-year bond yield has fallen 0.7% to -0.55% during the same period. pic.twitter.com/46JWrXUZB2

— jeroen blokland (@jsblokland) September 14, 2018

The peculiar arithmetic of fixed-income investments basically makes short-dated bonds more sensitive to interest-rate changes. So when short-term rates spike, that means traders are anticipating higher rates from the Fed. But when, at the same time, they're also worried about longer-term growth, they'll still buy 10-year debt, pushing prices higher and yields lower and thus "inverting" the curve.

An inverted yield curve has also been an uncanny predictor of recession, according to data from the St. Louis Fed, foretelling each and every pullback in economic growth for the past 60 years.

However, rising U.S. Treasury supply could add upward pressure to mid and longer-term bond yields, preventing the curve from inverting even as the Fed maintains its hawkish stance.

In its quarterly refunding statement, published last month, the Treasury said it would need to raise an additional $30 billion this quarter, and as such would be increasing the size of benchmark auctions by $1 billion. Earlier this week, a sale of $35 billion in 3-year notes, the biggest auction of its kind since 2010, drew the highest yield (2.821%) since May of 2009.

America's August budget deficit nearly doubled from the same period last year, the Treasury said yesterday, to $214 billion, taking the fiscal year total (October to September) to just under $900 billion, a 24.2% increase from the prior period.

The Treasury issued $1.079 trillion in new bonds, T-Bills and notes last month, the highest of the year, taking the 2018 gross total to $10.675 trillion, a figure that translates (once maturing bonds are subtracted) to a net cash increase of $1.206 trillion.