How Much Can the Fed Hike Before the Yield Curve Inverts?

The market expects a 100% chance of a hike in June and a 78.2% chance of at least one more hike by September. Then what?

December Rate Hike Odds

10-Year Treasury Yield vs Fed Funds Rate

10-Year Treasury Yield Minus Fed Funds Rate

When Will the Yield Curve Invert?

Assuming the 10-year yields remains at 3.0% or above, the Fed can get in five hikes without inversion.

If the 10-year yield stays at 3.0%, the curve would be perfectly flat. Everything from 3 months to 10 years would be at 3.0%.

Let's call that unlikely, to say the least.

If yields on the long end do not go up, some portion of the curve is likely to invert after four hikes.

If yields on the long end drop, three rate hikes may cause inversion.

Spreads are already the tightest since 2007.

As the Fed hiked rates, the spreads between rates have narrowed. The difference between durations is often under 20 basis points, with a single hike measuring 25 basis points.

10-Year Minus 2-Year

Less than 50 basis points.

10-Year Minus 5-Year

Less than 20 basis points.

5-Year Minus 2-Year

Less than 40 basis points.

30-year Minus 10-Year

Less than 20 basis points.

Unless the long end of the curve rises, an inversion is coming if the market expectation regarding the number of hikes is accurate.

Mike "Mish" Shedlock

One thing not factored in is how rising rates will affect the US budget. The higher the short term rate, the higher the borrowing costs for US gov't debt. Hard to predict how the market will react to that.

"One thing not factored in is how rising rates will affect the US budget. The higher the short term rate, the higher the borrowing costs for US gov't debt. Hard to predict how the market will react to that." Seems like the market goes up as deficits go up.

The govt bond bubble has already started popping in the periphery. It will spread to Europe, Japan, and eventually the US (core). Who, other than the ECB will want long-term govt paper - which begs the obvious question, why would stocks decline when there is no where else to hide for the big money?

The problem is twofold rising yields imply higher risk, however most of this risk is in the currency exchange market, so US domestic (mom and pop) bond buyers are somewhat immune to the risk. Foreign buyers can use derivatives, but higher interest rates raise the cost of currency insurance. The risk to the domestic bond buyer then becomes inflation, and so you have to ladder in your purchases. The Feds role in all this is to raise rates to a level which will attract buyers in order to keep government funded. For the buyers the need is to put money to work, and spread their rate exposure over time. TIPs are showing a rising BE level, which implies downside risk should rates fall. So the TIP fund is lagging while the TIP bond auctions have gone off at or near par. All this says is that rates are projected to bootstrap higher, while inflation is pretty much locked in around 2%. The Fed USG would like you (mom and pop) to go all in, (so they can fund all their spending and to that end they need a war so they can call them war bonds) by implying that rates are going to peak, before they come down. This is the general idea, the Fed is raising so it can lower rates when the recession they cause by raising rates goes into effect Ergo the stock market is fighting the fed on rate hikes, although today not so much. The problem for buyers is who to believe and how to allocate the great reallocation as I call it. The next decade belongs to government bond salesmen, and the buyers will sell their stock market holdings if the price is right and they have confidence that they know which way rates are going. In short if the Fed turns around and drops rates everyone loses confidence, and things crash. The Great Reallocation has to be done in measured steps, add water, add frog, turn on heat. Since real underlying inflation is tame they have some room. Meanwhile what are the other CBs doing? There's the rub.