Rate cuts came too late! Bond traders believe the Fed is seriously lagging behind

According to the Zhītōng Finance APP, last Friday, the bond market issued multiple warning signals of a potential economic recession, one of which was the change in the relationship between the 2-year and 10-year US Treasury bond yields.

Based on the analysis by Nicholas Colas, co-founder of DataTrek, the sharp drop in the 2-year Treasury yield has narrowed the spread between it and the Federal Funds Rate (the main tool for the Federal Reserve to control monetary policy) to the lowest level in at least 50 years. During this period, the spread between the two short-term rates has only fallen below -1 percentage point three times, and each time this has happened, the US economy has entered a recession within a year.

However, Colas does not believe that an economic recession will definitely occur this time. He pointed out that an economic recession requires a triggering factor, and currently there is no event significant enough to trigger a significant slowdown in the US economy. He explained that the yield curve inversion this time more indicates that bond market traders are becoming increasingly concerned that the Federal Reserve has not lowered borrowing costs, especially in the face of a slowdown in the labor market.

In a report on Monday, Colas stated, "The bond market is telling us that the Federal Reserve is seriously lagging behind in cutting interest rates."

Federal Reserve Chairman Powell and other senior officials have hinted that the Fed is expected to announce its first rate cut since the COVID-19 pandemic later this month. As of last Friday, the spread between the Federal Funds Rate and the 2-year Treasury yield was -1.68 percentage points. According to Dow Jones market data, the 2-year Treasury yield closed at 3.651% last Friday, the lowest level since September 2022, while the Federal Funds Rate remained around 5.33%, in the middle of the Fed's target rate range.

Investors typically view the bond market as a barometer of economic health. Last Friday, the spread between the 2-year and 10-year Treasury yields returned to positive territory 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 has been considered a reliable indicator of an economic recession. Although the recession widely predicted on Wall Street at the end of 2022 has not yet arrived, it does not mean it won't happen. Some bond traders believe that the return to a positive yield curve is often the final step before an economic contraction.

Last week, concerns about the Fed's slow action were not limited to the bond market. These concerns also led to a significant sell-off in the stock market, with the S&P 500 index recording its largest decline since the collapse of Silicon Valley Bank.

Colas is not the only market observer to point out the sharp drop in the 2-year yield. Jeff deGraaf of Renaissance Macro noted that the difference between the 2-year yield's four-week moving average and the Federal Funds Rate fell to its lowest level since 2008 last Friday. Like Colas, deGraaf is also hesitant to view this as a clear signal of an economic recession, but he warned that this is not the only market indicator hinting at potential risks He stated in the report: "The spread between the 2-year yield and the federal funds rate is approaching the level of 2008 (the last balance sheet recession). Although it is not yet like a balance sheet recession, the credit spread is starting to widen, and the yen is strengthening, both of which are signs of liquidity tightening."