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Bond Report: 2-year Treasury yield hits highest since October 2007, inverting curve further as traders look to next week’s Fed decision

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The yield on the 2-year Treasury note climbed for a sixth straight trading session on Thursday, reaching its highest level since October 2007, as investors penciled in the likelihood of another large interest rate hike by the Federal Reserve next week.

Meanwhile, the rise in the 2-year rate outpaced that of the 10-year yield, leading to a more deeply inverted Treasury curve that’s seen as a worrisome sign of the outlook.

What yields are doing

The yield on the 2-year Treasury note
TMUBMUSD02Y,
3.877%

rose 8.9 basis points to 3.871% from 3.782% at 3 p.m. Eastern on Wednesday. That’s the highest level since Oct. 31, 2007, based on 3 p.m. yields, according to Dow Jones Market Data.

The yield on the 10-year Treasury note
TMUBMUSD10Y,
3.455%

rose 4.7 basis points to 3.458% from 3.411% Wednesday afternoon. That’s the highest since June 14.

The 30-year Treasury bond yield
TMUBMUSD30Y,
3.472%

rose 1.1 basis points to 3.479% versus 3.468% late Wednesday.

Meanwhile, the 1-year yield intermittently touched or rose above 4%.

What’s driving the market

Traders continue to adjust to the notion of a Federal Reserve that’s resolute in bringing down inflation, even if it means breaking something in the U.S. economy. Government debt sold off, pushing the one-year Treasury yield periodically above 4%, a level that traders say could spill over into other rates and frighten equity markets.

Yields continued to rise on Thursday on the view that policy makers will keep hiking rates and leave them higher for longer, with the policy-sensitive 2-year yield climbing further above the 10-year rate and deepening an inversion of that part of the Treasury curve. The spread between the two yields narrowed to minus 41.3 basis points. The counterpart spread between 5- and 30-year Treasury yields shrank to minus 19.3 basis points.

Expectations for the Fed to raise its benchmark interest rate by at least 75 basis points when policy makers meet next week were cemented by an August consumer-price index that came in higher than expected. Fed funds futures traders are pricing in a 20% chance of a jumbo-size hike of 100 basis points, or a full percentage point, and an 80% chance of a 75-basis-point increase, according to the CME FedWatch Tool.

See: The biggest Fed rate hike in 40 years? It could be coming next week

In economic data on Thursday, retail sales rose a mild 0.3% in August, beating economists’ expectations. Two regional gauges of manufacturing sentiment, the Philadelphia Fed and Empire State manufacturing indexes, moved into slight contraction territory in September.

U.S. initial jobless claims fell for a fifth straight week to a three-month low, and U.S. industrial output softened in August.

What analysts say

“Beyond the impact on the U.S. economy, investors remain cautious on the demand destruction linked to the tightening by all the major global central banks,” with the exception of the Bank of Japan, said Ian Lyngen and Ben Jeffery, strategists at BMO Capital Markets.

“Given this backdrop, we’re anticipating the run-up to the FOMC (FederalOpen Market Committee) decision and the knee-jerk price action will be defining for the direction of U.S. rates during the fourth quarter,” they wrote in a note.

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