One of the bond market's most widely followed gauges of an impending U.S. recession ended at its lowest negative level in two months on Friday, after December producer price data bolstered expectations that inflation will remain low.
The two-year yield BX:TMUBMUSD02Y fell 12.2 basis points to 4.136% in New York trading, putting it 18.7 basis points above the 10-year benchmark rate BX:TMUBMUSD10Y.,
Which ended at 3.949%.
Normally, the 10-year yield should trade higher than its two-year counterpart, creating an upward-sloping Treasury yield curve. When this does not happen, it means that the curve is inverted, with the difference between the two rates less than zero. On Friday, the two- to ten-year spread ended roughly where it was earlier in the day, at its lowest negative level since November 1.
One of the most reliable indicators of a recession in the bond market is a shift to less negative.
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In theory, the spread between two and ten years tends to be less negative as a US recession approaches due to bond market expectations that the Fed will start cutting interest rates. This time, however, the inverted curve and expectations of lower interest rates have less to do with economic growth prospects and more to do with lower inflation, according to Lawrence Gillum, a senior fixed income strategist based in Charlotte, North Carolina. For LPL Financial's broker-dealer.
“It's more about the pure disinflation story that's still going on and inflation getting back to 2% faster than expected,” Gillum said by phone on Friday. “The narrative that not shifting means a recession because the Fed will start cutting interest rates is not what's happening. The idea is that the Fed will start cutting, regardless of the recession, as inflation declines.”
Friday's shift in the Treasuries curve occurred despite events in the Middle East, which caused oil prices to hold at a one-week high and has the potential to revive inflation. Treasury yields fell mostly as a result of bullish trades, as the shorter-term part of the market rose more than the longer-term end. This caused the two-year bond yield to fall more than the 10-year bond yield on Friday.
The spread between two and ten years began to fall into negative three-digit territory during the first half of 2023 amid growing concerns about the fallout from the Fed's interest rate hike campaign.
For now, one sign that the market is not currently anticipating a U.S. recession can be found in federal funds trading, according to Gillum. The strategist said traders expect “much more” than 150 basis points of interest rate cuts, or six quarter-point moves, by the end of the year if they sense an economic downturn approaching. As of Friday, federal funds futures traders saw a 29.3% chance of six quarter-point cuts by December and a 38.8% chance of seven cuts.
