U.S. Yield Curve Flattest Since 2008 as Traders Boost Fed Wagers

  • Gap between two-, 30-year yields narrows as policy makers meet
  • Traders predict no rate rise Wednesday, 80% chance in 2016

The gap between yields on Treasury two- and 30-year debt fell to the least since 2008 as traders boost wagers that the Federal Reserve will raise interest rates this year.

Treasury two-year note yields climbed to a two-month high while 30-year yields were little changed as policy makers began their two-day meeting. Futures prices indicate traders have added to bets that the Fed will raise rates this year even as they assign almost no chance of an increase at the central bank’s gathering that ends Wednesday.

Improving U.S. economic data in recent weeks have boosted the outlook for Fed policy tightening even as central banks abroad have maintained or added to stimulus. Citigroup’s Economic Surprise Index for the U.S., which measures the strength of data relative to analysts forecasts, climbed to minus 5.1 on Tuesday, the highest closing level since November, after falling to an eight-month low of minus 55.7 on Feb. 4.

"We will probably go back now to a ‘nearly balanced’ risk assessment,” said Larry Milstein, managing director of government-debt trading at R.W. Pressprich & Co. in New York, regarding the Fed’s reading of U.S. economic conditions. “That’s opening it up for the Fed to tighten again. As the market anticipates more Fed tightening, you’ll see the curve flatten."

Treasury two-year yields rose one basis point, or 0.01 percentage point, to 0.96 percent as of 5 p.m. New York time Wednesday, according to Bloomberg Bond Trader data, the highest since Jan. 6. The price of the 0.75 percent note due in February 2018 was 99 19/32.

Fed Dots

The yield difference between two-year Treasuries, which are more sensitive to Fed policy, and 30-year bonds, which are more influenced by expectations for inflation and economic growth fell to 176 basis points, the least on a closing-price basis since December 2008.

Derivatives traders see about an 80 percent chance the Fed will raise rates by December, up from a 54 percent probability assigned on Feb. 29, according to futures data compiled by Bloomberg. The calculation assumes the effective fed funds rate will average 0.625 percent after the Fed’s next hike. Traders see a 4 percent chance of an increase Wednesday.

"The Fed needs a string of data over the course of multiple months in order to have confidence to move forward," said Tom Tucci, managing director and head of Treasury trading in New York at CIBC World Markets Corp.

The gap between yields on Treasury Inflation-Protected Securities and nominal 10-year notes, known as the break-even rate, indicates inflation will average about 1.51 percent over the next decade. That’s below the Fed’s 2 percent forecast. WTI crude-oil prices fell for a second day, after tumbling 3.4 percent on Monday. 

The Fed had indicated at its December meeting plans for four rate increases this year. Policy makers will update those projections, known as the dot plot, at the conclusion of their meeting Wednesday.

"The dots will be more realistic," said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC in Philadelphia. "They were a little bit higher than we had priced in."

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