The recent attention on Nvidia’s results may have overshadowed a significant development in the bond market. The spread between the 2- and 10-year Treasury yields, a key indicator of a looming recession, is starting to normalize after inverting back in June 2022. This inversion has historically preceded most U.S. recessions since World War II, signaling a slowdown in long-term economic growth.
While the recession has not yet materialized, the resolution of the yield curve inversion does not guarantee smooth sailing ahead. Typically, the yield curve normalizes before a recession as traders anticipate the Federal Reserve’s need to lower interest rates to combat economic stagnation. Market expectations point to potential rate cuts by the Fed starting in September and continuing through at least the end of 2025.
While market watchers focus on the 2- and 10-year yield relationship, the Fed closely monitors the 10-year compared to the 3-month Treasury. According to the New York Fed, this relationship had suggested a 56% chance of a recession over the next year as of July, although that likelihood has been diminishing.
Nicholas Colas, co-founder of DataTrek Research, explained that the correlation between high Fed Funds rates and 3-month Treasury yields often leads to a recession. If the Fed maintains policy rates above neutral levels implied by 10-year yields, the U.S. economy tends to contract. However, Colas noted that recessions typically require a significant event like an oil price spike or financial crisis to occur.
Despite the absence of such a crisis, Colas emphasized the importance of the Fed cutting rates over the next year to normalize monetary policy and mitigate the risk of a recession. While it may seem aggressive for markets to anticipate rate cuts at every meeting in the coming year, it aligns with the necessity for the Fed to recalibrate its policies for the foreseeable future.
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