The US Treasury yield curve is no longer inverted, marking the end of an era

The non-farm data did not provide an answer to whether there will be a 25bp or 50bp rate cut in September. The market's pricing for a rate cut in September has slightly decreased from 35bp to 33bp, but the rate cut expectations for the end of 2025 have increased by 10bp.

Figure 1: Changes in implied interest rate expectations in the interest rate futures market before and after the non-farm data

Mixed Feelings about the Non-Farm Data, Market in a Dilemma

From the data perspective, a 4.2% unemployment rate and a 0.4% hourly wage increase are not enough to support a 50bp rate cut by the Federal Reserve in September. However, various employment data in the United States are indeed showing a clear slowdown trend: the addition of 142,000 jobs is lower than the expected 165,000 jobs, with a downward revision of 86,000 jobs in the previous two months, bringing the three-month average of new jobs to 116,000, the lowest level since the 2020 pandemic.

The market trend is also quite mixed. Initially, after the data was released, the US dollar and US bond yields rebounded, but a few seconds later, they began to decline rapidly. Subsequently, there was a rebound after Williams' speech, followed by a drop after Waller's speech, and shortly after, it calmed down again...

Figure 2: Changes in market expectations for a rate cut in September on Friday night

Most Hawkish Official Turns Dovish, Rate Cut Expectations Rise

After the data was released, three Federal Reserve officials made speeches, but none clearly stated whether they support a 25bp or 50bp rate cut, leaving the market to continue guessing... Among them, the previously most hawkish official, Waller, unexpectedly turned dovish, stating that if necessary, he would support a larger rate cut, causing a direct drop in the 2-year US bond yields.

At 21:00, New York Fed President Williams' speech was relatively neutral: "Now is an appropriate time to reduce the degree of policy constraints by lowering the federal funds rate target range. The economy is in balance, and the monetary policy stance can gradually transition to a more neutral stance over time."

At 23:00, the previously most hawkish Fed Governor Waller unexpectedly turned dovish: "The labor market is 'persistently weak, but not deteriorating,' and the time to lower the policy rate has come. I support a preemptive rate cut, and if necessary, I will support a larger rate cut."

At 22:30, Chicago Fed President Evans (non-voting member): "Market pricing is very similar to the Fed's forecast. The outcome of the next meeting itself is not the most important, but the rate cut path in the coming months is more crucial." As long as the long-term trend shows a decline in inflation, our tolerance for a slight upside surprise in CPI will slightly increase. I am concerned that if we maintain this tightening level, the possibility of an economic recession may increase

What does the end of the curve inversion mean?

From July 2022 to August 2024, the current U.S. Treasury yield curve has been inverted for 26 months, setting a record for the longest in history. Recently, as the labor market weakens and rate cut expectations drive short-term rates sharply lower, the era of inversion has finally come to an end.

A popular saying recently is: Every time the yield curve inversion ends, it is often accompanied by an economic recession.

The economic explanation behind the shape of the yield curve is as follows:

1. In the early stages of the economic cycle, when the economy overheats, the central bank begins to raise interest rates, starting with an increase in short-term yields, often resulting in a steep curve.

2. When significant rate hikes reach restrictive levels, due to cooling inflation and economic expectations, the term premium of long-term yields declines, leading to the inversion of the yield curve.

3. Yield curve inversion often leads to credit contraction. As banks both attract deposits and lend out funds through a "borrow short, lend long" process, the narrowing of the spread between short and long-term rates reduces banks' willingness to lend, and businesses also reduce new investments, leading to an overall economic slowdown and increased risk of recession.

4. In the late stages of the economic cycle, as economic growth weakens, market expectations of a significant rate cut by the Federal Reserve increase, causing short-term rates to rapidly decline, resulting in a steepening curve.

5. The Federal Reserve is often behind the curve, and by the time they start cutting rates, the economy is already facing issues. Therefore, the yield curve steepens rapidly after the inversion ends, often heralding the arrival of a recession.

Figure 3: 10Y-2Y U.S. Treasury yield rates, with red shading representing recession periods

However, the current economic cycle post-pandemic is significantly different from historical patterns. The duration of the inversion in this cycle has set a historical record, and the maximum inversion depth of -110 basis points is the deepest in the past forty years.

The reason the U.S. economy has remained resilient under such a prolonged inversion is twofold: first, the sensitivity of businesses and households to high interest rates has decreased, as U.S. businesses locked in long-term loans at low rates between the pandemics, and U.S. households accumulated significant excess savings during the pandemic; second, banks have maintained a healthy net interest margin, as deposit rates for U.S. savers have not fully kept pace with rate hikes, while loan rates in the U.S. are benchmarked to the base rate, allowing banks to maintain a relatively high pace of credit growth.

Therefore, the end of the U.S. Treasury yield curve inversion does not necessarily imply an impending economic recession.

Is the rate cut expectation too aggressive?

Upon seeing the 4.2% unemployment rate, my initial reaction was: it's stable, there won't be a 50 basis point rate cut in September. However, the post-nonfarm market trends have left me puzzled:

The 2-year U.S. Treasury yield has dropped from 3.74% to 3.64%, a 10 basis point decrease, but the 10-year U.S. Treasury yield is hovering around 3.7%, showing a stable trend. The performance of U.S. Treasury yields post-nonfarm data tells a story: the short end is pricing in multiple significant rate cuts over the next 2 years, while the long end rates are not pricing in a recession, indicating a soft landing Looking ahead, I believe the Federal Reserve will not choose to cut interest rates by 50 basis points in September to avoid creating additional panic in the market. However, more important than the rate cut magnitude at the September FOMC meeting is the interest rate expectations on the September dot plot.

Currently, based on the expectations of the futures market, there is an anticipated cumulative rate cut of 115 basis points (4.6 times) by the end of 2024, and a cumulative rate cut of 253 basis points (10.1 times) by the end of 2025. In comparison, the June meeting dot plot expects 2 rate cuts by the end of 2024 and 6 rate cuts by the end of 2025. Considering the current labor data indicating a "softening" but not a "recession," the Federal Reserve is unlikely to provide more aggressive rate cut expectations than what the market has priced in. If the market overreacts again, I continue to see upside potential for the U.S. dollar to rebound from the support level at 100.5.

Figure 4: Dot plot for June 2024 compared with the futures market's interest rate expectations

Author: Fang Yuqi, Source: Good Morning Market, Original Title: "The End of an Era for the U.S. Yield Curve"