Market Extra: The yield curve is steepening, and that’s not good for investors. Here’s why

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The yield curve is steepening, but that doesn’t mean all is right in the world again for Wall Street.

Analysts say a wider spread between short-term and long-term yields can signify a brightening economic landscape, but analysts say the recent curve-steepening in the past few days is sending a more pessimistic message on the U.S. growth outlook.

The gap between the two-year note yield TMUBMUSD02Y, -4.13%   and the 10-year note TMUBMUSD10Y, -2.47%  widened to 11 basis points Wednesday, its largest spread in two months, from negative-4 basis points on Aug. 27, Tradeweb data shows.

This widely-watched measure of the curve had inverted briefly a few weeks ago, sparking concerns that the bond market was forecasting a recession in the next one to two years.

“Though the data is getting weaker, the slope of the curve is actually becoming more normal,” wrote Kevin Giddis, chief fixed-income strategist at Raymond James.

A steeper yield curve can point to better economic times ahead as bolstered expectations for growth and inflation can weigh on the value of long-term government bonds, pushing their yields higher than short-term peers, which are more attuned to shifts in monetary policy.

However, investors noted in the case of a “bull steepening” of the curve, when short-term yields fall faster than their longer-term counterparts, a wider spread was a more worrying sign. In effect, bond traders were casting doubt on the Federal Reserve’s insistence that the past two rate cuts were no more than a mid-cycle adjustment, and that further policy easing should be expected.

On Wednesday, the two-year note yield fell 7.8 basis points to 1.482%, a much steeper drop than the 5.7-basis-point decline for the 10-year note rate, which ended at 1.594%.

In fact, some say the steepening of the curve is often the more troubling prelude to a coming recession, noting that yield spreads tend to expand sharply after a recession as expectations for rate cuts heat up.

“The price reaction in the [Treasury yield] curve following the ISM print was a testament to the market quickly pulling forward the expectations surrounding the timing and magnitude of the easing campaign,” wrote Jon Hill, an interest-rate strategist at BMO Capital Markets.

Investors saw fresh cracks in the U.S. economy following lackluster employment and factory data this week. The Institute for Supply Management’s manufacturing gauge fell to a reading of 47.8% in September, its lowest since June 2009. And Automatic Data Processing Inc. reported the private sector had added just 135,000 jobs in September, pushing average monthly job growth in the past three months down to 145,000, compared with 214,000 over the same period last year.

The increased pessimism over growth took a toll on the stock market. On Wednesday, the S&P 500 SPX, -1.79%  ended lower by 1.8%, and the Dow Jones Industrial Average DJIA, -1.86%  closed down around 1.9%. Both equity benchmarks had their worst day in six weeks.

See: 5 things investors need to know about an inverted yield curve