The US Treasury yield curve has ended its inversion, is the recession trigger officially activated?

Due to weaker-than-expected labor market data supporting bets on a significant rate cut by the Federal Reserve, a key part of the US Treasury yield curve briefly ended its inversion on Wednesday.

The announcement on Wednesday that US job openings in July fell to their lowest level since early 2021 stimulated traders to further bet on a significant rate cut by the Federal Reserve this month. US Treasury prices surged, with short-term bonds more sensitive to the Fed's monetary policy leading the rally, causing the yield on two-year US Treasuries to fall below the 10-year yield for the second time since 2022.

John Fath, Managing Partner of BTG Pactual Asset Management LLC in the US, said, "The Fed may need to cut rates faster, possibly even by 50 basis points. If they do so, the yield curve should completely stop inverting."

Interest rate swap trading shows that traders have fully priced in the expectation of a 25 basis point rate cut by the Fed at this month's policy meeting, with the possibility of a 50 basis point cut exceeding 30%. They expect a total of 110 basis points of rate cuts in the remaining three meetings this year.

Wall Street economists and fund managers have been closely studying economic data, looking for signs of weakness that could compel the Fed to start a significant rate-cutting cycle. Data released on Wednesday showed a decrease in new job openings, further proving that the labor market is softening, which has raised concerns among Fed officials. Job growth has been slowing, the unemployment rate is rising, and job seekers are finding it harder to secure employment, intensifying concerns about a potential economic downturn.

Earl Davis, Head of Fixed Income at Montreal Bank Global Asset Management, stated that the evidence of weakness in the US labor market is significant because it "lowers the threshold for the Fed" to cut rates by 50 basis points later this month. He said, "Once they start easing with a 50 basis point cut, it won't be a one-time thing. They have enough room to cut rates."

As traders believe there is more room for Fed rate cuts, options measuring the expected volatility of US interest rates have also surged.

Yield Curve Normalization

The yield on two-year US Treasuries fell sharply on Wednesday, closing at 3.754%, slightly below the 10-year yield of 3.755%, nearly eliminating the phenomenon of an inverted yield curve. Historically, the bond yield curve slopes upward as investors hold cash in longer-term US Treasuries due to uncertainty, seeking higher yields or returns. However, in March 2022, as the Fed embarked on its most aggressive tightening cycle in decades, the yield curve inverted. By March 2023, the yield on two-year Treasuries was 111 basis points higher than the 10-year yield, marking the largest inversion since the early 1980s After a long period of inversion, the yield curve is now returning to a normal upward slope, which typically occurs when the Federal Reserve begins to cut interest rates. As the Federal Reserve tends to ease policy when the economy faces obstacles, this reversal has heightened investors' concerns about an economic recession.

"I mean, once the yield curve normalizes, it signals the beginning of a recession," said Ryan Hayhurst, President of The Baker Group, which provides consulting services to over 1,000 community banks and credit unions across the United States.

However, for decades, strategists and even some Federal Reserve officials have underestimated the predictive power of the yield curve. Prior to the COVID-19 pandemic, many on Wall Street warned that the recession signal from the inverted yield curve was distorted due to the Federal Reserve keeping rates at unusually low levels. Last year, a strategist at Bank of America suggested that expectations of a hard landing for inflation, driven by the Federal Reserve's tightening policy to control price pressures, fueled this inversion.

Now, the focus is on the reversal of the curve inversion. Jerome Schneider, Head of Short-Term Portfolio Management and Financing at Pacific Investment Management Company, said, "This is a healthy development and should be welcomed. A normal yield curve shape indicates that the business and monetary policy environment is closer to normal and balanced."

Simon White, a macro strategist at Bloomberg, stated, "The unreliability of the yield curve inversion signal also means that the end of the inversion does not necessarily herald an impending recession."

Priya Misra, Portfolio Manager at J.P. Morgan Asset Management, said, "The end of the curve inversion is significant as we are on the eve of the Federal Reserve cutting rates." She added that the market's reflection of accommodative measures "is consistent with the Fed's desire to normalize rates to maintain the idea of the soft landing we are currently in."

Federal Reserve Chairman Powell explicitly stated last month at the Jackson Hole symposium that he intends to prevent further cooling of the labor market and indicated that the time has come for the Fed to lower key policy rates. This has drawn attention to the non-farm payroll report to be released on Friday. Steven Zeng, U.S. Rate Strategist at Deutsche Bank, said that Friday's data will be a "key factor" in deciding whether the Fed chooses to cut rates by a significant 50 basis points or more conservatively by 25 basis points