US Treasury Yield Curve Inversion Ends: Has the Recession Trigger Been Pulled?

A key segment of the US Treasury yield curve briefly ended its inversion on Wednesday, as weaker-than-expected labor market data fueled bets on a significant Federal Reserve rate cut.

The US reported on Wednesday that job openings in July fell to their lowest level since early 2021, prompting traders to increase bets on a sharp rate cut by the Fed this month. US Treasury prices surged, with short-term bonds—more sensitive to Fed policy—leading the gains. This caused the yield on two-year Treasury notes to drop below the 10-year yield for the second time since 2022.

John Fath, Managing Partner at BTG Pactual Asset Management US LLC, stated, “The Fed may need to cut rates more aggressively, possibly by 50 basis points. If they do, the yield curve should fully normalize.”

Fed interest rate cut

Interest rate swaps show that traders have fully priced in a 25 basis point rate cut by the Fed this month, with the probability of a 50 basis point cut exceeding 30%. They also anticipate a total reduction of 110 basis points over the remaining three meetings this year.

Wall Street economists and fund managers are closely analyzing economic data for signs that could trigger a major easing cycle by the Fed. Recent data revealed a drop in job openings, reinforcing concerns about a softening labor market and intensifying worries about a potential recession.

Earl Davis, Head of Fixed Income at BMO Global Asset Management, emphasized the significance of weak labor market evidence, noting it "lowers the threshold" for a 50 basis point cut later this month. He added, “Once they start with a 50 basis point cut, it won’t be a one-time event. They have room to cut further.”

Fed Chair Jerome Powell, in his Jackson Hole speech last month, made it clear that he intends to prevent further cooling of the labor market and suggested that the time for rate cuts is approaching. This has heightened anticipation for Friday’s nonfarm payroll report. Steven Zeng, US Interest Rate Strategist at Deutsche Bank, noted that Friday’s data will be a “key factor” in determining whether the Fed opts for a significant 50 basis point cut or a more conservative 25 basis point reduction.

With increased expectations for Fed rate cuts, volatility in rate swaps measuring US interest rate expectations has surged.

Normalization of the Yield Curve

On Wednesday, the yield on two-year US Treasury notes fell sharply to 3.754%, slightly below the 10-year yield of 3.755%, nearly eliminating the inversion. Historically, the bond yield curve slopes upward as investors seek higher returns on longer-term Treasuries due to uncertainty. However, since March 2022, the yield curve inverted with the Fed's aggressive tightening cycle. By March 2023, the two-year yield was 111 basis points higher than the 10-year yield, marking the largest inversion since the early 1980s.

After an extended period of inversion, the US Treasury yield curve is reverting to a normal upward slope, typically occurring when the Fed begins to cut rates. This shift has heightened investor concerns about a potential recession, as the Fed often eases policy in response to economic challenges.

Ryan Hayhurst, President of The Baker Group, remarked, “Once the yield curve turns positive, it signals the beginning of a recession.” The firm provides consulting services to over 1,000 community banks and credit unions across the US.

Analysis from strategists

However, the predictive power of the yield curve has often been underestimated by strategists and some Fed officials. Prior to the pandemic, many on Wall Street warned that the inversion signal was distorted due to the Fed’s prolonged low interest rates. A strategist from Bank of America noted last year that expectations of a hard landing due to the Fed’s tightening had driven the inversion.

Currently, attention is focused on the curve’s normalization. Jerome Schneider, Head of Short-Term Portfolio Management and Financing at PIMCO, described it as “a healthy development and should be welcomed,” indicating a return to a more normal and balanced business and monetary policy environment.

Bloomberg macro strategist Simon White pointed out that the unreliability of the yield curve inversion signal means that its end does not necessarily herald an imminent recession.

Priya Misra, Portfolio Manager at JPMorgan Asset Management, added, “The end of the inversion is significant as we approach the Fed’s rate-cutting phase.” She noted that the degree of easing reflected by the market “aligns with the Fed’s intention to normalize rates to sustain the current soft landing.”

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