Huge selloff rocks Treasury markets, yield curve inverts

© Reuters. FILE PHOTO: U.S. One dollar banknotes are seen in front of displayed stock graph in this illustration taken, February 8, 2021. REUTERS/Dado Ruvic/Illustration/File Photo

By Yoruk Bahceli and Sujata Rao

(Reuters) - U.S. two-year Treasury yields rose above 10-year borrowing costs on Monday -- the so-called curve inversion that often heralds economic recession -- on expectations interest rates may rise faster and further than anticipated.

Fears that the U.S. Federal Reserve could opt for an even larger rate hike than anticipated this week to contain inflation sent two-year yields to their highest levels since 2007.

At the same time, a view that aggressive rate hikes could raise recession risks was playing out.

The gap between two and 10-year Treasury yields fell to as low as minus 2 basis points on Monday, Tradeweb prices showed. The curve had inverted two months ago for the first time since 2019 before normalising.

An inversion of this part of the yield curve is viewed by many as a reliable signal that recession could come in the next year or two.

The move follows inversions on Friday in the three-year/10-year and five-year/30-year portions of the Treasury curve, after data showed inflation continued to accelerate in May.

Two-year Treasury yields rose to a 15-year high around 3.25%, while 10-year yields touched the same level, the highest since 2018.

Friday's data showed the largest annual U.S. inflation increase in nearly 40-1/2 years, dashing hopes the Federal Reserve could pause its interest rate hike campaign in September. Many reckon the central bank may actually need to up the pace of tightening.

Barclays (LON:BARC) analysts said in fact they now expected a 75 bps move from the Fed on Wednesday rather than the 50 bps which has been baked in.

Futures also now see a 20% chance of a 75 bps move next week and if implemented, that would be the biggest single-meeting hike since 1994.

UBS strategist Rohan Khanna said hawkish ECB communication alongside the inflation print "have completely shattered this idea that the Fed may not deliver 75 bps or that other central banks will move in a gradual pace".

"The whole idea went out the drain..."that's when you get turbo-charged flattening of yield curves. It is just a realisation that peak inflation in the U.S. is not behind us, and unless we are told so, maybe peak hawkishness from the Fed is also not behind us," Khanna added.

Money markets are also upping their bets on the U.S. terminal rate -- where the Fed funds rate may peak this cycle. On Monday, they priced rates to approach 4% in mid-2023, up 50 basis points in a week's time.

Deutsche Bank (ETR:DBKGn) said they now saw rates peaking at 4.125% in mid-2023.

The bond market selloff has set other markets on edge, sending German 10-year yields to the highest since 2014 and knocking S&P 500 futures 2.5% lower.