As risk-off sentiment swept the globe on Wednesday and handed U.S. stocks their worst day since late 2022, the bond market was acting in a rather strange way.
Shorter-term U.S. government debt rallied, sending the policy-sensitive 2-year yield to its lowest level in more than five months or almost 4.42%. Meanwhile, long-term Treasurys sold off, pushing the 10-year benchmark yield to a two-week high of nearly 4.29%. The result was a narrowing difference or spread between the two yields that left this part of the Treasury curve at its least-inverted level since July 12, 2022, or minus 13 basis points.
Ordinarily, the 10-year yield BX:TMUBMUSD10Y trades above its 2-year counterpart BX:TMUBMUSD02Y when traders assume brighter U.S. economic growth prospects ahead, leaving the so-called 2s10s spread as positive.
Instead, the spread has been inverted or below zero for two full years as higher interest rates from the Federal Reserve’s inflation fight took hold, raising expectations for an eventual U.S. economic downturn. Though it can take up to two years for a contraction to emerge after this part of the Treasury curve starts to inverts, a recession still has yet to materialize.
Conventional wisdom is that the 2s10s curve becomes less inverted, as it did on Wednesday, as a recession actually draws near.
But the next-day analysis of what happened in Treasury-market trading on Wednesday now includes some analysts’ doubts that a less-inverted 2s10s spread automatically means a recession is moving closer. That’s because it is equally possible that the Fed might be able to lower interest rates by enough to secure a soft landing and help the world’s largest economy dodge a downturn.
The 2s10s spread “was previously a good recession indicator because it reflected the Fed’s response to high inflation, which was to raise rates by enough to bring inflation down. But there are a lot more cross currents right now,” said economist Derek Tang of Monetary Policy Analytics in Washington, a firm founded by former Fed Gov. Larry Meyer.
Via phone on Thursday, Tang said “the curve is basically a collection of views and reflects a weighted-average view of the market. It works when the market has a pretty good read on the economy.” Right now, though, “it’s much more difficult to forecast recessions because there are so many more forces at play,” including the possibility that the government might become more active with fiscal policy.
Moves like those in the 10-year Treasury note, which rallied on Thursday, are now capturing traders’ expectations on everything from inflation and growth to corporate profits and a less-stable U.S. political system, in which neither major party is seen as likely to curtail the federal deficit, according to Tang.
“The bond market does not exist in a vacuum,’’ he said. “Investors are thinking about whether to devote funds to bonds or equities, and bonds might be more attractive than they used to be if the profit picture for equities looks less certain.”
Wednesday’s trading did reinforce at least one piece of conventional wisdom, which is that the 2s10s spread tends to go less negative following a prolonged period of inversion on rising assumptions that the central bank needs to start cutting rates. This was the case on Wednesday and again on Thursday, when fed-funds futures traders priced in a 100% chance of at least a quarter-point rate cut from the Fed by September. Traders mostly priced in a total of five or six quarter-point cuts through next June.
On Thursday, U.S. stocks DJIA SPX COMP closed mostly lower, while long-dated Treasurys rallied — sending the 2s10s spread further below zero again to minus 18.7 basis points.
Meanwhile, BMO Capital Markets strategists Ian Lyngen and Vail Hartman described the steepening Treasury curve seen on Wednesday as one sign that “global markets are in the process of shifting to trade the realities of the next phase in the policy cycle.”
This next phase is expected to include a narrowing difference between the policies of the Fed and the Bank of Japan in coming months, with a September rate cut by the U.S. central bank widely seen as the start of a series of cuts, the strategists wrote in a note on Thursday.
Read: Stock-market drop offers reminder that rate cuts can alarm investors too