Longest Ever US Long-Short Term Interest Rate Inversion... Will It Begin to Resolve in the Second Half?

Timing of Base Rate Cut in September 'Solsol'
Presidential Race Kicks Off in Earnest
Biden and Trump Both Interested in Fiscal Spending

"Short-term Bond Yields Fall While Long-term Bond Yields Remain High
Ending the Longest Ever Inversion of Short- and Long-term Yields Lasting Two Years"

The inversion phenomenon where the yield on the 2-year U.S. Treasury note is higher than that of the 10-year note is expected to begin resolving in earnest from the second half of this year. The timing for the Federal Reserve's interest rate cut, which puts downward pressure on short-term bond yields, is anticipated to be in September. Additionally, President Joe Biden and former President Donald Trump officially entered the presidential race, starting with their first TV debate on the 27th (local time). Analysts expect both candidates to unveil policy measures involving massive fiscal spending to win votes, which will result in long-term bond yields remaining at elevated levels.

[Image source=Reuters Yonhap News]

On the 26th, Bloomberg reported that "the Federal Reserve's potential interest rate cut in September and the start of the U.S. presidential race will serve as catalysts to normalize the two-year-long inversion between short- and long-term Treasury yields in the bond market."

The phenomenon of the 2-year U.S. Treasury yield exceeding the 10-year yield has persisted since July 2022, marking the longest duration on record. Recently, the 10-year U.S. Treasury yield stood at approximately 4.33%, about 0.42 percentage points lower than the 2-year yield of around 4.75%. Typically, longer maturity bonds carry higher yields due to increased default risk. However, when the Fed aggressively raised interest rates to curb inflation caused by COVID-19 in 2022, short-term yields rose sharply, while long-term yields, which move based on economic outlooks, did not follow suit. While an inversion between short- and long-term yields is usually interpreted as a recession signal, it has persisted unusually even as U.S. job growth and economic expansion continue.

The Fed's pivot (direction change) point is expected to be the first watershed moment in resolving the short- and long-term yield inversion. According to the Chicago Mercantile Exchange (CME) FedWatch tool, 6 out of 10 market participants predict the Fed will cut interest rates in September, with a high possibility of two rate cuts.

Both President Biden and former President Trump, now in the presidential race, are unlikely to tighten fiscal spending even if elected, which is also expected to help resolve the yield inversion. Currently, Treasury debt stands at $27 trillion, more than six times the amount in 2007, and the Congressional Budget Office (CBO) projects it will rise to about $50 trillion by 2034. The Treasury will issue more long-term bonds to cover fiscal deficits, leading to an increase in long-term bond yields. Bloomberg explained, "Since U.S. debt will increase under any administration, a higher risk premium (additional compensation for bearing risk) on long-term Treasury holdings will be demanded, pushing long-term yields higher."

The current risk premium on the 10-year Treasury yield is about -0.27%, significantly lower than the 0.46% recorded last October when fiscal concerns were severe. TD Securities stated, "The election could highlight fiscal debt risks, potentially turning the risk premium positive." There is also speculation that if one party controls both the White House and Congress, regardless of whether it is the Democrats or Republicans, legislation will be easier to pass, which could further increase the risk premium.

Some analysts suggest that if former President Trump wins, the long-term bond risk premium could rise sharply. He has previously indicated intentions to limit the Fed's authority, and if the central bank's independence is compromised, investors will demand a higher risk premium.