The Federal Reserve is more than a beat behind on rate cuts? The bond market is sounding the alarm!
According to the analysis of Nicholas Colas, co-founder of DataTrek, the warning signals from the bond market indicate that the Federal Reserve is lagging behind in rate cuts. The significant drop in the 2-year US Treasury yield has led to the spread between short-term rates and the federal funds rate reaching its lowest level in 50 years, and historically, such inversions often herald the onset of an economic recession. However, Colas believes that the catalyst for a recession has not yet emerged. The recent changes in the bond market, coupled with the sharp decline in the S&P 500 index, reflect concerns in the market about the Federal Reserve's slow response
Nicholas Colas, co-founder of DataTrek, stated that the long-term relationship between the 2-year and 10-year Treasury yields changing was not the only recession warning signal sent out by the bond market last Friday.
The significant drop in the 2-year Treasury yield has also pushed the spread between short-term notes and the federal funds rate to the most negative level in at least 50 years. Colas pointed out that during this period, the spread between these two short-term rates has only fallen below -1% three times, and each time this happened, an economic recession began within a year.
However, Colas does not believe this will necessarily lead to an economic recession. He said that an economic recession needs a catalyst to start, and so far, there has been nothing happening in the U.S. that could trigger such a severe economic slowdown.
Instead, this inversion indicates that bond traders are increasingly concerned that the Fed is not lowering borrowing costs promptly in the face of a slowing labor market.
Colas stated in a report on Monday, "The bond market is saying: the Fed is far behind the curve in cutting rates."
Powell and other senior officials have hinted that the Fed will cut rates later this month for the first time since the early days of the COVID-19 pandemic.
Investors often see the bond market as a barometer of economic health. Last Friday, the spread between the 2-year and 10-year Treasury yields turned positive for the first time in over two years, ending the longest period since the late 1970s of short-term rates being higher than long-term rates.
Historically, an inverted yield curve in the Treasury market has been a reliable indicator that an economic recession is imminent. However, the widely predicted economic recession on Wall Street at the end of 2022 has not materialized yet. This does not mean it won't happen. Some bond traders suggest that the yield curve returning to positive territory is often the final step before the economy begins to contract.
Last week, concerns about the Fed acting too slowly were not limited to the bond market, as the S&P 500 index recorded its largest decline since the collapse of Silicon Valley Bank.
Colas is not the only one to notice the significant drop in the 2-year Treasury yield as a significant development in the market. Jeff deGraaf of Renaissance Macro pointed out that the difference between the four-week moving average of the 2-year Treasury yield and the federal funds rate fell to the lowest level since 2008 last Friday.
Like Colas, deGraaf is also reluctant to interpret it as a definite signal of an impending recession. But he warned that this is not the only market indicator signaling trouble ahead.
In his report, deGraaf said, "The spread between the 2-year Treasury yield and the federal funds rate is now approaching levels last seen in 2008, which was during the last balance sheet recession. While it is not yet like a balance sheet recession, credit spreads are starting to widen, and the yen is strengthening, both signs of a loss of liquidity."