The Bond Market Has Just Flashed a Reliable Recession Warning. Don’t Panic.

A weakening jobs market and the expectation of Federal Reserve interest rate cuts have triggered a reliable recession signal in the bond market. On Friday, two key parts of the approximately $28 trillion U.S. Treasury yield curve turned positive after a prolonged period of inversion. This shift is significant because the yield curve's inversion—when shorter-term yields are higher than longer-term ones—has historically been a strong indicator of an impending economic downturn.

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Specifically, the 10-year Treasury yield ended Friday at 3.71%, while the 2-year yield finished at 3.65%. This marked the first time since July 1, 2022, that the 10-year yield closed higher than the 2-year rate, according to data from Dow Jones Market Data. While this may sound complex, it essentially reflects how investors on Wall Street are positioning themselves ahead of the Federal Reserve’s expected interest rate cuts, which many believe will occur before the U.S. economy experiences significant damage.

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Since late August, bond yields have been falling steadily following comments from Federal Reserve Chair Jerome Powell. Powell indicated that a rate cut, the first in four years, could be on the horizon. Investors are now anticipating that the Federal Reserve will reduce interest rates during its upcoming policy meeting on September 17-18. Historically, changes in the Treasury yield curve have been closely watched by Wall Street because rate cuts are often used by the Fed as a tool to support a struggling economy.

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In the past, movements along the yield curve have been seen as a precursor to a recession. John Flahive, head of fixed income at BNY Wealth, noted that such signals were once considered strong indicators. However, he believes the yield curve may no longer have the same predictive power due to the increasing size and interconnectedness of the global bond market. Over the past 15 years, major central banks have taken extensive measures, such as using their balance sheets, to stabilize markets and the economy. These actions may have led to “false signals” from traditional recession indicators.

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“I think history rhymes, but doesn’t necessarily repeat,” Flahive told MarketWatch. He also remains optimistic about the possibility of a "soft landing" for the U.S. economy, meaning that any downturn would be mild rather than severe. Flahive expects that rate cuts during this cycle will be more gradual compared to the sharp reductions seen during past crises.

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However, the pace of Federal Reserve rate cuts remains a topic of debate. Investors are increasingly nervous about the likelihood of an economic contraction. On Friday, U.S. stocks took a hit, with major indices like the Dow Jones Industrial Average and the S&P 500 experiencing their largest weekly losses since the regional banking crisis in March 2023. The tech-heavy Nasdaq Composite also posted its biggest weekly loss since January 2022.

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Economists are now closely analyzing the latest jobs data to gauge the direction of the economy. In August, the U.S. economy added 142,000 jobs, a figure that fell short of expectations. Despite this, the unemployment rate dipped slightly to 4.2%. According to Aditya Bhave, a U.S. economist at BofA Global, this jobs report has increased the urgency for the Federal Reserve to lower rates. “We are changing our Fed call,” Bhave wrote in a client note on Friday. He now predicts that the central bank will cut interest rates by 25 basis points at each of the next five meetings, bringing the policy rate down to around 4% by March 2025. This rate is considered to be near the upper end of what economists refer to as the "neutral rate," where monetary policy is neither stimulating nor restricting economic activity.

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Thursday saw an initial move where the 10-year Treasury yield briefly rose above the 2-year yield during intraday trading, but it did not hold that level until the close. The closing inversion reversal on Friday marked the end of a record 546 consecutive trading days in which the yield curve was inverted, according to Dow Jones Market Data.

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The significance of the 10-year yield surpassing the 2-year yield is that it often signals the potential onset of a recession. However, it is important to remember that the countdown to a potential recession typically begins only once the 10-year yield consistently closes above the 2-year yield. This shift may indicate that the market is adjusting in anticipation of Federal Reserve rate cuts, but it also highlights broader concerns about the economic outlook. Investors remain cautious, keeping a close eye on the Federal Reserve’s next moves and the potential impact on the broader economy.

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In summary, the bond market has just signaled a potential recession, as key parts of the yield curve turned positive after a long period of inversion. Investors are positioning themselves for upcoming Federal Reserve rate cuts, expected to be announced in mid-September. While some remain concerned about an economic slowdown, others believe the yield curve may no longer be as reliable an indicator due to the global nature of modern bond markets. Either way, all eyes are now on the Federal Reserve as it prepares to navigate a delicate economic landscape.

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