The Bond Market is About to Do Something Noteworthy While NVIDIA is Distracting Everyone

While much of the market's attention was directed towards Nvidia's earnings report on Thursday, a significant development was unfolding in the bond market. The spread between the 2-year and 10-year Treasury yields, a well-known indicator of potential recession, is showing signs of returning to normal levels after being inverted for a considerable period.

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On Thursday, the difference between the 10-year and 2-year Treasury yields had narrowed to less than 2 basis points, signaling a possible end to the inversion. This inversion, where short-term yields exceed long-term yields, is traditionally viewed as a warning of an impending economic downturn. However, the fact that the yield curve is normalizing does not necessarily indicate that the threat of a recession has passed.

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Historically, the yield curve tends to normalize just before the onset of a recession. This is often because traders begin to anticipate that the Federal Reserve will need to lower interest rates to combat an economic slowdown. Currently, market expectations are aligned with the idea that the Fed may start cutting rates as early as September, with continued reductions likely through at least the end of 2025.

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While the market commonly tracks the relationship between the 2-year and 10-year Treasury yields, the Federal Reserve pays closer attention to the spread between the 10-year and 3-month Treasury yields. As of July, this relationship indicated a 56% probability of a recession within the next 12 months, according to data from the New York Fed. However, this probability has been decreasing recently.

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Nicholas Colas, co-founder of DataTrek Research, explained the dynamics behind this relationship in a recent market commentary. He noted that excessively high Fed Funds rates, which are closely tied to 3-month Treasury yields, often lead to recessions. The 10-year yield, on the other hand, reflects the market's best estimate of the neutral rate of interest. When the Fed maintains policy rates above these levels, the U.S. economy tends to contract.

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According to Colas, if this theory holds true, the U.S. economy may be facing a significant risk of an imminent recession. However, he also highlighted that recessions typically require an extraordinary event, such as a sharp increase in oil prices or a financial crisis, to trigger a downturn. In the absence of such a crisis, a recession has not yet materialized.

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Despite this, Colas emphasized that the Federal Reserve is not off the hook when it comes to cutting interest rates over the next year. Market participants are well aware of this, which is why futures markets are pricing in rate cuts at every Fed meeting over the coming year. While this may seem aggressive, it aligns with the idea that the Fed needs to gradually return to a more neutral monetary policy stance in the foreseeable future.

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As traders continue to monitor developments in both the bond market and the Federal Reserve's policy decisions, the overall outlook remains uncertain. While the potential end of the yield curve inversion could be seen as a positive sign, it also raises concerns about the possibility of an impending recession. The Fed's actions in the coming months will be crucial in determining the direction of the U.S. economy, as well as the bond market's response to those actions.

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In summary, while the bond market's recent movements may offer some relief to traders concerned about a prolonged yield curve inversion, the broader implications for the economy remain unclear. The relationship between short-term and long-term Treasury yields has long been a reliable indicator of economic health, but it is not foolproof. As the Fed navigates its monetary policy decisions, the market will be closely watching for any signs that a recession could still be on the horizon.

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