The U.S. bond market rout cranked up a gear last week, amid sticky inflation and firming expectations of a Federal Reserve rate hike, sending yields surging to multi-year highs. This grabbed the headlines, but the more telling story may be the shape of the yield curve.
The signals being sent by the relative moves between short- and longer-dated U.S. borrowing costs suggest bond investors are already looking beyond the inflation-fighting rate hikes likely coming down the pike and bracing for the economic slowdown that could follow.
The gap between two- and 30-year yields shrank on Friday to 71 basis points, the narrowest since late June. Shave off a few more basis points, and this will be the flattest curve since March last year.
The benchmark “2s/10s curve,” the gap between two- and 10-year yields, also shrank on Friday. It hit 31 basis points, the tightest spread since July 29. That’s a significant marker — it was the day of the Fed’s last policy decision and, most notably, Chair Kevin Warsh’s poorly received press conference when he offered only an equivocal commitment to the Fed’s 2 per cent inflation target. The yield curve steepened the most in a year that day, as investors bet that the Fed would fall further behind the curve and allow inflation to drift even higher.
Friday’s move was in the opposite direction. Traders are now betting that the elevated inflation numbers — and Warsh’s credibility concerns — will force the central bank to start a tightening cycle this week that could entail four quarter-percentage-point rate hikes within a year.
The yield curve flattening implies that the Fed will soon have to reverse course and loosen policy due to doubts about the economy’s ability to cope with the rise in the cost of money. Or, perhaps more specifically, consumers’ ability to handle it.
Last week was marked by several key milestones for the U.S. consumer, none of them positive. U.S. crude oil rose back above US$100 a barrel, while the average price of diesel scaled US$6 a gallon for the first time ever.
Meanwhile, the 10-year Treasury yield’s flirtation with 5 per cent helped push mortgage rates to the highest since May last year. The average 30-year mortgage rate is now back above 7 per cent, according to Mortgage News Daily.
These are big, round numbers, and it’s difficult to envisage a scenario where they don’t put the squeeze on consumer spending, which – as a reminder – accounts for around 70 per cent of all U.S. economic activity.
True, the economy is far less oil-intensive than it used to be, which helps to explain why this year’s 80 per cent price spike in crude hasn’t had a bigger economic impact. Energy spending accounted for 5.7 per cent of disposable consumer income in 2024, compared with nearly 10 per cent in the 1980s, according to the American Petroleum Institute. And energy represents around 5.5 per cent of GDP, nearly half its share in 2008, according to the U.S. Energy Information Administration. But soaring gasoline, diesel and fuel prices will still eat into discretionary spending.
A weak housing market could have an even bigger economic impact. Its footprint represented nearly 16 per cent of GDP in the second quarter across the whole sector, which includes construction, home improvements, rents, and fees. House price growth is already sluggish, and 7-per-cent mortgage rates aren’t going to turn that around.
Although President Donald Trump has often downplayed inflation and affordability issues, he may now be tuning into voters’ number-one concern going into the midterm elections. Last week, he pledged to give every adult in the country US$5,000 if Republicans win both houses of Congress in November.
But there’s a counterforce to these consumer headwinds that could cause the yield curve to reverse course and steepen yet again. Taken together, the fiscal whoosh from Washington and the massive artificial intelligence build-out, are running into the trillions of dollars, with significant inflationary — and growth — implications.
The Trump administration has made no secret of its desire to run the economy hot. Its policies on immigration, energy, defense, trade, and the deficit all appear to be inflationary in the near term. Similarly, the historic wave of AI-related borrowing and investment is inflationary, although AI optimists believe it will eventually morph into a productivity boom that will ultimately be disinflationary.
That may or may not transpire. Right now, AI investment is an inflationary force, and it’s a big one. Skanda Amarnath, co-founder and executive director of Employ America, estimates that around one third of the overshoot in inflation is down to AI.
This is why nominal growth is still so strong despite the many headwinds. Current annual nominal GDP growth of 6.6 per cent is the highest since 2005, excluding the post-pandemic period, according to Deutsche Bank economists. Since 1990, excluding pandemic-related distortions, nominal growth has been higher in only six quarters.
The recent rumblings in the AI world about the need to slow model development for safety reasons could signal that the AI investment tailwind may weaken, but at this stage, that remains a big “if.”
Either way, bond investors appear to be bracing for what lies beyond this boom. Will it be bust? Watch the yield curve.