Treasury Rally Ignites Debate on How Fast Fed Needs to Cut
A major rally in the $27 trillion Treasury market is laying bare anxiety that the US economy is sliding into recession and the Federal Reserve will need to start aggressively cutting interest rates.
US government debt surged Monday, pushing two-year yields — which are sensitive to monetary policy — below that of the 10 year note for the first time in two years. That brief normalization offered a vivid indication that growth concerns are fueling expectations for super-sized rate reductions starting in September, or sooner.
“The Fed likely realizes now that they made a mistake last week” by holding borrowing costs steady at a two-decade high, said Campbell Harvey, the economist credited with linking the yield curve with economic growth. The yield curve has normalized — or disinverted — just before the past four recessions, he pointed out, underscoring the case for lower rates. “The Fed has waited too long to take action.”
Bond prices stabilized through the day, with short-term yields ending higher, leaving the curve inverted again as long-term yields fell slightly. Yields rose on Tuesday in Asia trading, further paring losses in previous sessions.
But over the past week, the two-year yield plunged more than 70 basis points to as low as 3.65% on Monday, compared to a peak this year of 5.04% reached in late April. Ten-year yields dropped as low as 3.67%.
Alongside those moves, swaps traders priced in at least five quarter-point Fed rate cuts in 2024, with about 16% probability that the US central bank opts for an emergency reduction before its next scheduled two-day meeting wraps on Sept. 18. Traders who in July made what appeared to be long-shot bets on supersized Fed cuts are now in line to reap huge profits.
The extreme moves Monday were pared after data showed the US services sector expanded in July, helping to allay fresh angst about a broad slowing in the economy.
However, sentiment remains on the fritz after Friday’s increase in the unemployment rate caused its three-month moving average to exceed the 12-month low by half a percentage point. According to the Sahm rule — devised by former Fed economist Claudia Sahm — that means a recession is underway.
Treasuries surged after that jobs report last week, turning into one of the most powerful bond-market rallies since fear of a banking crisis flared in March 2023. The sense in markets is that Chair Jerome Powell and his colleagues are behind on cutting rates.
“The shape of the yield curve is one of several indicators that helps gauge the market’s assessment of recession risks,” said Wei Li, global chief investment strategist at BlackRock. “The recent steepening reflects the market’s assessment that the Federal Reserve is behind the curve and will cut rates more aggressively over the next few years.”
That’s stoking debate around the Fed’s next steps. Citigroup Inc. and JPMorgan Chase & Co. last week predicted the central bank would lower its benchmark by a half-point at both its September and November meetings.
