U.S. and European 2-Year Yields Surge; Bear Flattening

The most significant shift in global financial conditions in September 2026 was the sharp month-over-month rise of 40–55 bp in U.S. and European 2-year yields. The increase was led by the short end of the curve, pointing to tighter financial conditions. The ECB raised its deposit facility rate from 2.25% to 2.50%, but the deposit rate–2Y gap widened instead. The U.S. 10-year yield reached 5.26%, moving above 5%, while the 10Y–2Y spreads narrowed in both the U.S. and Europe, producing a bear-flattening pattern. The combined assets of the three central banks (approximate dollar equivalent) contracted for a second consecutive month, to $16.75 trillion.

1. Interest-rate conditions in three regions: short-end-led surge in the U.S. and Europe

Conclusion: In both the U.S. and Europe, 2-year yields rose more than 10-year yields. Financial conditions have shifted further toward tightening.

In both regions, yields rose more sharply at the short end. Two-year yields are sensitive to the policy rate outlook, and this pattern is consistent with an upward revision to expectations for policy rates. However, the available data do not include indicators that decompose expected rates from other factors.

United States: assessment with missing Fed Funds rate data

According to data published by FRED, the U.S. 2-year yield rose 137 bp, from 3.520% in January to 4.890% in September. After a temporary decline in February, it rose for seven consecutive months from March onward. Data for the Fed Funds rate are missing from January (3.640%) onward, so the September policy rate–2Y gap cannot be calculated. For reference, the January gap was +12 bp, indicating that the market was pricing in a modest rate cut at the time. Without actual policy rate data, it is not possible to verify the direction of current market expectations for policy rates.

Euro area: gap widens even after rate hike

According to ECB data, the deposit facility rate was raised to 2.25% in June and 2.50% in September. The deposit rate–2Y gap is -71 bp. The negative gap widened by 15 bp from -56 bp the previous month, reaching its widest level year to date. The 2-year yield’s rise of +41 bp exceeded the +25 bp increase in the deposit rate. This widening may indicate that the market does not view the latest rate hike as the end of the cycle.

Japan: monthly assessment limited by missing JGB data

JGB yield data published by the Ministry of Finance are missing from February onward. As of January, the 10Y–2Y spread was 0.996%, and the call rate–JGB 2Y gap was -52 bp. These figures indicate that the market was pricing in BOJ rate hikes at the start of the year. However, it is not possible to quantitatively assess Japan’s September financial conditions from an interest-rate perspective.

So What: In the euro area, the gap widened even after the policy rate increase, with market rates rising ahead of the policy rate. For the U.S., policy rate data do not allow us to confirm whether the same pattern applies, so the assessment is limited to the change in the 2-year yield.

2. Yield curve shape: bear flattening in the U.S. and Europe; slope at half its level at the start of the year

Conclusion: Level rose sharply, while slope narrowed. The same change in shape is evident in both the U.S. and Europe.

The slope in both the U.S. and Europe has nearly halved since the start of the year. In September, yields rose while the slope narrowed, a typical bear-flattening pattern.

• Level: The U.S. 10-year yield rose +53 bp from the previous month to 5.26%, while the European 10-year yield rose +33 bp to 3.61%. The available data do not show whether these increases were driven by inflation expectations or real rates.
• Slope: The 10Y–2Y spread narrowed because 2-year yields rose as much as or more than 10-year yields. This pattern is consistent with an upward shift in the expected path of short-term rates.
• Long end: The U.S. 30Y–10Y spread narrowed by 16 bp. The 30-year yield’s increase (+37 bp) was smaller than that of the 10-year yield (+53 bp).

Alternative interpretation: Given that the 10-year yield rose by more than 50 bp in one month, some may argue that a widening term premium was the primary driver. When term-premium expansion is the main driver, longer maturities generally tend to see larger increases. In fact, both the 30Y–10Y and 10Y–2Y spreads narrowed, making the observed pattern more consistent with an expectations-driven interpretation. However, the available data do not include a direct measure of the term premium, so no definitive conclusion can be drawn.

So What: The slope remains positive, and the curve shape does not suggest that the market is clearly pricing in a recession. However, if flattening continues and the curve approaches inversion, that would signal growing concern that monetary tightening could weigh on economic activity.

3. Excess liquidity and the balance sheets of three central banks: only the FRB expands, while the ECB and BOJ contract

Conclusion: Balance-sheet direction diverged between the FRB and the ECB and BOJ. Overall, liquidity absorption continues.

The ECB’s balance sheet contracted in seven of the past eight months, making it the most consistent QT (quantitative tightening) phase. The BOJ recorded the largest contraction among the three central banks in September. The FRB’s balance sheet has been expanding modestly and is not in a contraction phase in terms of total assets.

The combined assets of the three central banks (approximate dollar equivalent) declined from $16.90 trillion in July to$16.75 trillion in September. Note that the step-up in the July total reflects the addition of BOJ data; it does not indicate an actual surge in liquidity.

Money supply: U.S. M2 growth slows, while Japan’s M2 is flat

• U.S. M2: Year-over-year growth was +5.62% in August, slowing from +6.43% in July. Even so, growth remained above the 4% range seen at the start of the year.
• Japan M2: At 12,963,895 hundred million yen in September, it was nearly flat, down 0.05% from the previous month. It also remained at the same level as in July.
• Europe M3: Data are missing after year-over-year growth of +3.44% in January, making it impossible to assess recent credit creation.

So What: The FRB’s balance-sheet expansion and U.S. M2 growth in the 5% range indicate that quantitative liquidity remains abundant in the U.S. Yet U.S. yields have surged, so quantitative indicators and interest-rate movements are not aligned. Without Fed Funds rate data, we cannot attribute this divergence to the policy rate outlook.

4. Cross-regional spreads: U.S.–Europe 10-year spread reaches a year-to-date high of 165 bp

Conclusion: The U.S.–Europe 10-year spread widened by +20 bp from the previous month to 1.652%, strengthening the relative advantage of dollar interest rates.

The spread widened because the U.S. 10-year yield’s increase (+53 bp) exceeded that of the European 10-year yield (+33 bp). The U.S.–Europe 10-year spread has widened 30 bp from 1.357% in January. Yields are rising in both regions, but the faster increase in the U.S. means the rate differential is widening even as the two regions move in tandem.

Data on the U.S.–Japan and Japan–Europe 10-year spreads are missing from February onward. As of January, the U.S.–Japan spread was 2.013% and the Japan–Europe spread was -0.656%. The current U.S.–Japan spread and yen carry environment cannot be assessed without JGB yield data.

So What: A widening U.S.–Europe rate differential tends to encourage a shift of funds from euro assets to dollar assets. Higher dollar funding costs increase the burden on entities with dollar-denominated debt.

5. Inflation environment: Japan’s slowing inflation contrasts with rising U.S. and European yields

Conclusion: Japan’s CPI has remained below 2%, presenting a different inflation backdrop from the period of rising yields in the U.S. and Europe.

According to data from the Statistics Bureau of Japan, August CPI was +1.9% year over year for the headline index, +1.7% for core, and +1.9% for core-core. In autumn 2025, headline and core inflation were around 3%, but inflation has slowed considerably from those levels. Core inflation fell 0.1 percentage point from +1.8% in July.

So What: This suggests that inflation provides less impetus for Japan to raise rates urgently. However, without data on Japan’s policy rate and JGB yields, it is not possible to verify how this inflation environment is reflected in the Japan–U.S. and Japan–Europe rate differentials.

6. Real economy: Japan’s economic indicators are at their highest levels in the period shown

Conclusion: As of July, the Cabinet Office’s economic indicators for both leading and coincident activity were at their highest levels in the period shown.

The July CI leading index was 117.7, up +1.5 points from the previous month. The coincident index was 120.6, up +1.7 points. The leading index has risen from 104.3 in May 2025. However, data for October–December 2025 are missing, and the values for May and June 2026 are identical, so a continuous upward trend cannot be confirmed.

So What: High economic indicator readings could support the BOJ in maintaining a tightening stance even as inflation slows. The balance of emphasis between inflation and economic activity will be a key factor shaping the direction of Japanese interest rates.

7. Business sentiment: recent conditions improve, while the outlook remains cautious

Conclusion: In the 2026-Q2 BOJ Tankan, business conditions under “recent” improved markedly. By contrast, respondents expected conditions to deteriorate under “outlook.”

• Large manufacturers: recent conditions were 22, up +5 points from the previous quarter; the outlook was 14, an expected deterioration of 8 points.
• Large nonmanufacturers: recent conditions were 37, up +1 point; the outlook was 29.
• Medium-sized manufacturers recorded 17 and small manufacturers 9, indicating improvement across all business sizes.

So What: The wide gap between recent conditions and the outlook shows that businesses recognize current strength while remaining wary of a deterioration ahead. Note that the Q2 survey was conducted before the September surge in U.S. and European yields, so no direct link with the latest rate increases can be established.

8. Japan’s external position: assessment based on limited data

Conclusion: Trade balance data are limited to October–December 2025 and are insufficient to assess recent yen supply and demand.

According to Ministry of Finance trade statistics, the trade balance showed a deficit of 242.9 billion yen in October. It then moved to modest surpluses of 306.0 billion yen in November and 94.8 billion yen in December. Exports rose to 10,407.7 billion yen in December.

So What: The trade balance was near equilibrium in October–December 2025. However, without recent trade data and Japanese interest-rate data, it is not possible to draw implications for current yen supply and demand or the carry trade environment.

9. Outlook and risk scenarios

Base case: If the short-end-led rise in U.S. and European rates continues, the yield curve is likely to keep flattening. In the euro area, the key question is whether the ECB will raise rates further in response to the -71 bp gap. The combined balance sheets of the three central banks will continue to decline gradually if contraction at the ECB and BOJ persists.

Risk scenarios

• If U.S. 2-year yields rise further relative to 10-year yields: If 2-year yields rise more than 10-year yields by an amount exceeding the current U.S. 10Y–2Y spread (+37 bp), the curve will invert. This could signal recession concerns and create a channel through which higher dollar funding costs put pressure on financing in emerging markets and Europe.
• If U.S. rates turn sharply lower: The U.S.–Europe rate differential could narrow, unwinding the shift of funds into dollar assets. The scale of the impact on yen carry trades cannot be assessed without Japanese interest-rate data.
• If the ECB halts rate hikes: Expectations reflected in the deposit rate–2Y gap (-71 bp) could unwind, leading European 2-year yields to fall. In that case, the short-term U.S.–Europe rate differential would tend to widen.

Watchpoints

• Actual Fed Funds rate: Recalculate the U.S. policy rate–2Y gap and assess whether rate hikes are priced in.
• ECB deposit rate–2Y gap: Track whether it narrows from -71 bp or widens further.
• U.S. 10Y–2Y spread: Monitor whether it narrows further from 0.37% and approaches zero (yield curve inversion).
• BOJ monetary base: Check whether the -2.15% contraction pace persists.
• Japan core CPI: Track whether inflation falls further from 1.7%.

Data sources

• Source: Federal Reserve Bank of St. Louis (FRED), https://fred.stlouisfed.org/
• Source: European Central Bank, Statistical Data Warehouse
• Source: Ministry of Finance, Japan Government Bond Interest Rate Information
• Source: Bank of Japan, Time-Series Data Search
• Source: Statistics Bureau of Japan, Consumer Price Index; Cabinet Office, Economic Indicators; Ministry of Finance, Trade Statistics; Bank of Japan, Tankan

Glossary

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This column was automatically generated by AI integrating data from the Federal Reserve Bank of St. Louis (FRED), the European Central Bank (ECB) Statistical Data Warehouse, Japan Ministry of Finance, and Bank of Japan statistics as a global fiscal and liquidity analysis resource. This is not a recommendation to buy or sell any financial instruments. Please make investment decisions at your own responsibility and consult professionals as needed.