3-Month/10-Year Yield Curve Disinversion Signals Market Relief

3-Month/10-Year Yield Curve Disinversion Signals Market Relief 

The financial landscape is evolving as the yield curve between the 3-month and 10-year U.S. Treasury notes approaches positive territory. This shift holds greater significance than the widely observed 2-year/10-year yield curve. A transition to positivity in the 3-month/10-year curve could help alleviate the strain on primary dealer balance sheets burdened with U.S. Treasuries. This adjustment may ease leverage constraints across stock and bond markets while potentially allowing swap spreads to recover.

Human nature is prone to error, and persisting in misconceptions compounds the issue. Markets, known for their tendency toward oversimplification, have a recurring habit of misinterpreting the yield curve's relationship with economic recessions. This persistent misreading reflects a broader misunderstanding of the curves that genuinely matter to market stability and economic insight.

For instance, the 2-year/10-year yield curve attracted considerable attention when it turned positive earlier this year. However, the 3-month/10-year curve's approaching disinversion likely holds more substantial implications. This change could unburden dealer balance sheets, reducing the risk of abrupt liquidity withdrawals while paving the way for swap spreads, currently at historic lows, to begin normalizing.

The notion that an inverted yield curve signals an inevitable recession has become ingrained in market lore. However, history shows this relationship is neither a guaranteed nor exclusive precursor to economic downturns. Moreover, the idea that a disinverted curve foreshadows an immediate recession is equally flawed. For instance, the 2-year/10-year curve inverted several months ago, yet no recession has materialized, and none appears imminent in the near term.

These misconceptions highlight the diminishing reliability of the yield curve as a recession predictor, especially in the current financial system. This context makes the 3-month/10-year curve's potential disinversion far more relevant than its 2-year/10-year counterpart. Yield curve inversions traditionally deter carry traders—investors who profit from the difference in short-term borrowing costs and long-term yields—from purchasing U.S. Treasuries. Over time, the curve self-corrects, but the system's ample reserves have left U.S. banks with excess cash, which they find unprofitable to hold.

As a result, large banks have maintained lower deposit rates, even as the Federal Reserve raised interest rates, discouraging additional inflows. This dynamic provided large banks with a cheaper funding source than money market rates suggest. Despite the broader yield curve inversion, large banks continued buying long-term Treasuries due to the favorable yield gap between the 10-year Treasury and deposit funding rates.

This demand exerted downward pressure on long-term yields, resulting in one of the longest yield curve inversions on record. Meanwhile, carry traders remained on the sidelines, and primary dealers accumulated record-high Treasury inventories. Without recent bank buying, dealer inventories could have been even higher.

Dealer balance sheets are vital for providing leverage within the financial system. As these balance sheets grew more constrained, financial markets experienced increasing strain. Two significant consequences have been persistently low swap spreads and tighter equity financing, raising the risk of a leverage-driven correction in stock markets if funding availability is curtailed.

However, the approaching disinversion of the 3-month/10-year curve offers a glimmer of hope. This development is likely to attract carry traders back into the market, reducing the reliance on dealers to absorb Treasury supply. This shift could alleviate pressure on dealer balance sheets and reduce the likelihood of sudden leverage withdrawals that could destabilize markets.

Japan's role as a significant carry trade player further underscores the importance of the 3-month/10-year curve. Japanese investors, who favor U.S. Treasuries when the yield curve is positive and foreign exchange hedging costs are low, have been closely watching the curve. For them, the critical factor is the yield difference between the 10-year Treasury and the shorter-term hedging cost, typically ranging from three to twelve months.

Recent trends indicate that dealer inventories of Treasuries are already beginning to decline as the FX-hedged carry for Japanese investors improves. As the curve moves from being flat to slightly positive, demand for Treasuries is expected to increase further, allowing dealers to offload their balance sheet-clogging inventories.

Shorter-dated yield curves, such as the 3-month/10-year curve or the FX-hedged curve for Japanese investors, are particularly influential for several reasons. Foreign investors who hedge their currency exposure typically do so on a rolling basis, with short-term horizons in mind. Similarly, dollar-based carry traders focus on shorter-term rates, often funding their positions at rates tied to the Secured Overnight Financing Rate (SOFR) rather than at the 2-year point.

The 10-year versus SOFR curve, which closely aligns with the 3-month/10-year curve, is also on the verge of disinversion. Over recent days, these curves have flattened after a period of steepening, a trend that gained momentum following Scott Bessent's nomination as Treasury Secretary. Bessent has criticized the Treasury's increased reliance on short-term bill issuance to fund the deficit—a strategy he views as politically motivated and inflation-prone. If confirmed, he may prioritize reducing bill issuance as a share of total debt, potentially stabilizing the market.

Even with such adjustments, broader forces—such as resilient economic growth, abundant liquidity, and persistent government deficits—are likely to continue steepening the yield curve. Rising excess liquidity, driven by money growth outpacing economic expansion, diverts demand away from long-term risk-free assets, fueling rallies in riskier markets and contributing to a steeper yield curve.

Nonetheless, countervailing factors could limit the extent of this steepening. Swap spreads are expected to rise as dealer balance sheet constraints ease, attracting demand from leveraged Treasury buyers. Additionally, inflationary pressures may constrain the Federal Reserve's ability to cut rates further, tempering the curve's steepening potential.

The economic environment has been bolstered by a combination of factors, including the election of Donald Trump, which has reinforced themes of robust growth, ample liquidity, and a bull market in equities. However, large-scale government bond issuance remains a potential challenge for Treasury market liquidity and leverage provision.

The nearing disinversion of the 3-month/10-year yield curve suggests that while risks persist, they are likely to moderate. With Scott Bessent's focus on stabilizing macroeconomic conditions and financial markets, this development could mark a positive turning point for the nominee and the broader economic landscape.