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Parts of US Treasury market show concern about Fed rate-cutting pause
Karen Brettell
5 min read
By Karen Brettell
NEW YORK (Reuters) - Parts of the U.S. Treasury yield curve are reflecting increasing concerns that the Federal Reserve will wait too long before resuming interest rate cuts as economic growth slows.
That will draw even more focus to February’s jobs data, due on Friday, for signals on whether the economy is cooling faster than the U.S. central bank has anticipated.
The spread between yields of two-year and five-year notes is trading at around 3 basis points after very briefly turning negative last week for the first time since mid-December.
This part of the curve is worth watching because durable inversions have preceded major economic contractions and stock market declines for the past 35 to 40 years, said Tom Fitzpatrick, head of global market insights at R.J. O'Brien. “You've got to pay attention to this curve again because it never got it wrong.”
These inversions occurred in 1989, 2000 and 2006, in each case preceding a recession.
The curve also inverted in 2019, before a short economic downturn in 2020, though in this instance the Fed was quick to cut rates in 2020 to tackle economic disruption from COVID- related closures.
Another worrying sign is that benchmark 10-year yields last week fell back below the fed funds rate. The 10-year yields reached 4.12% on Tuesday, while the fed funds rate held steady at 4.33%.
“That is indicative of the economy essentially saying that the Fed is missing out here. It's behind the curve,” said Lou Brien, strategist at DRW Trading.
While the curve can invert for different reasons, it often reflects a concern over Fed policy when longer-dated debt yields decline faster than shorter-dated ones. This is because longer-dated yields react to growth fears, while shorter-dated debt yields will reflect Fed interest rate expectations, and the possibility that the U.S. central bank will hold rates too high for too long.
The closely watched spread between yields on three-month bills and 10-year notes also reinverted last week for the first time since mid-December. An inversion in this part of the curve is seen as an indicator that a recession is likely in the next 12-to-18 months.
The gap between two-year and 10-year yields, also a closely watched recession indicator, has flattened back to 25 basis points, from a peak of 48 basis points in January, but has not reinverted.
GROWTH WEIGHS ON LONG-END YIELDS
Longer-dated debt yields have been dragged lower by increasing concerns about U.S. economic growth, in part due to government job layoffs by Elon Musk’s Department of Government Efficiency.
Uncertainty over the impact of trade tariffs and other government policies is also weighing on consumer sentiment and dampening risk appetite.
“Markets went from over-exuberance about the economy, that things are doing so well, to activity might fall off a cliff again,” said Jan Nevruzi, U.S. rates strategist at TD Securities. For two-year yields, “it's a little bit more pinned because of the limited reaction function by the Fed.”
Optimism on Treasury supply has supported the decline in longer-dated debt yields, with the U.S. Treasury maintaining supply levels.
Two-year yields caught up a bit on Tuesday as traders boosted bets that the Fed may cut rates sooner. It came after new tariffs on Mexico and Canada took effect, while levies on Chinese goods increased.
Fed funds futures traders are now pricing in a roughly 50/50 chance of a rate cut now in May, with a move not fully priced in until June. The Fed cut rates by 100 basis points last year, starting in September, before pausing in January.
"The market wants to price in some greater likelihood of some Fed activity to a greater degree this year," said Michael Lorizio, head of U.S. rates trading at Manulife Investment Management.
To cut rates, however, the Fed will wait to see weakness in several economic metrics, he said.
For now, the market moves are not fully signaling a slowdown. Fitzpatrick says the shift in the 2/5 yield curve has reached a "code orange" level of caution. If it inverts decisively with drops in longer-dated yields leading the move it may constitute a "code red," especially if it drops to around minus 20 basis points.
For benchmark 10-year yields, Brien says further drops would be a stronger sign that the Fed may need to reconsider its policy. “If the 10s fall to 4% and the fed funds are still up at 4.5%, then it starts to look very suspect about the Fed having missed the turn and falling behind the curve."
JOBS DATA KEY
Clues about whether the United States is facing a more sustained downturn are likely to be in the jobs market, where hiring has slowed though layoffs remain relatively subdued.
That could change quickly, said Brien. “When it actually turns, it's going to turn sharply because the layoffs will come.”
Friday’s jobs report for February is expected to show employers added 160,000 jobs during the month, while the unemployment rate stayed steady at 4.0%, according to economists polled by Reuters.
Inflation will also remain a key focus that could keep the Fed on hold for longer if it reaccelerates.
The risk with the Fed is that it will wait too long to cut rates because it is “fighting yesterday's battle,” said Fitzpatrick.
(Reporting by Karen Brettell; Editing by Alden Bentley and Andrea Ricci)
