This rare phenomenon occurs when investors demand a higher rate of return to lend the federal government money for just two years rather than for a longer period of 10—normally the opposite is true. The immediate reason that fixed-income investors are currently so bearish about the outlook for the U.S. economy is Tuesday’s warning from the Federal Reserve.

In his semiannual testimony before the Senate Banking Committee, Chair Jay Powell wrong-footed markets by saying the terminal interest rate would likely have to be higher than previously anticipated. 

“Chair Powell was much more hawkish than we anticipated,” wrote the UBS global rates strategy team on Tuesday, adding that the two-10 spreads “blew through” the 100 basis point mark. The last time the gap was that high was 1981, during what the St. Louis Fed calls the period of “Great Inflation,” when yields on the two-year note hit 16% under former Fed Chair Paul Volcker.

Following Powell’s remarks, UBS argued the Fed appeared to reverse course and throw overboard its more cautious approach of hiking by 25 basis point increments, if at all.

Now a 50 basis point hike at the next Fed policy meeting on March 22 is a distinct possibility, despite the Fed’s preferred inflation gauge only ticking up one-tenth to 5.4% in January: “We thought it would take extraordinarily strong data to put larger hikes back on the table.”

Stockholders should always have an eye on the bond market for three reasons. 

First off, ultrasafe Treasuries form the minimum risk-free rate an investor can expect, upon which all asset prices ultimately derive. Second, bondholders more accurately predict fluctuations in the economic cycle, since corporate earnings typically lag. 

Third, its size is enormous, with $615 billion worth of Treasuries traded every day, excluding other fixed-income products like corporate debt and mortgage-backed securities. And the greater the liquidity, the more meaningful a market’s signals.

What exactly is meant by the yield curve?

The easiest way of viewing the bond market is not through its prices—as with equities—but rather its yields. These serve as the most common barometer of market appetite: When demand drops, yields rise as bondholders charge a higher return in exchange for the risk of accepting a fixed-rate coupon. 

Once we collate the yields for short-dated and long-dated Treasuries, we can chart the plot of the yield curve along the range of their respective maturities. 

“The Fed is excessively data dependent,” says @elerianm. “They lack a long-term view. They lack a monetary framework. Going to 25 basis points was a mistake.” pic.twitter.com/JP9xwVXOEH

— Squawk Box (@SquawkCNBC) March 8, 2023

The yield of a two-year Treasury note will typically be lower than that of its benchmark 10-year sibling, since the opportunity cost of holding a bond with a fixed coupon grows the longer its duration. 

This is because visibility over inflation—the worst enemy of a bondholder—steadily becomes murkier the further into the future one goes. 

Instead of the usual upward sloping curve, two-years are currently trading near 5% and 10-years at just below 4%.

Why is a yield curve inversion such a reliable signal?

Typically, the short end of the curve tracks the central bank’s thinking on the economy, reflecting the current views and economic analysis of its Federal Open Market Committee (FOMC). 

The Fed’s chief tool is setting a target for the overnight rate at which banks lend and borrow among themselves. That Federal funds rate currently hovers between 4.5% and 4.75%, following its Feb. 1 hike.

By comparison, the collective inflation expectations of bond investors reign supreme over the 10-year and 30-year Treasury market, where yields move more independently of the U.S. central bank. 

The Fed cannot directly influence longer duration rates through conventional means: The only exception is when it dips into its emergency toolkit and intervenes through outright asset purchases, as was the case with its 2011 “Operation Twist,” for example.

A yield curve inversion telegraphs to the Fed that the overall market is taking a far dimmer view of the economic outlook, implying the FOMC has lagged behind the market’s collective wisdom and needs to take swift action to stimulate demand by lowering rates.

Over time, that will then restore the conventional upward slope of the yield curve. By that point, however, it can be too late and the economy has already begun to contract.

That’s why the degree to which a yield curve is inverted merely predicts the likelihood of recession—but GDP doesn’t begin to actually shrink until the inversion has already been corrected.

Mohamed El-Erian, an influential economic commentator, warned the Fed was in the horns of a dilemma after reducing its rate hike to a quarter-point from the previous pace of a half-point. 

“They have to stop digging themselves such a deep hole,” he told CNBC on Wednesday.