The spread between two- and 10-year government bonds fell sharply over the past 10 days to 69 basis points as of Wednesday. The drop has been driven by an increase in short-term rates without corresponding increases in long-term rates. The two-year government bond is currently yielding 1.6%, while the 10-year is yielding 2.8%. Since the end of the third quarter, the two-year yield has risen 16 basis points, while the 10-year has been virtually unchanged.
The rise in the two-year is driven by investor anticipation of an upcoming federal funds rate increase. Under normal circumstances, longer-term rates would move in corresponding fashion as higher yields are demanded to account for future inflation. Recent increased demand for longer-term government issues has suppressed yields for these issues, with reciprocal effects on prices.
What does it all mean, Basil? On the surface, perhaps we're on the edge of the next recession. But forward equity price-to-earnings ratios, fueled by positive earnings reports, suggest healthy equity markets and investor confidence.