Shift in US bond yields leaves investors guessing about economic outlook

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Short-term US government borrowing costs have fallen below long-term costs in a reversal of the so-called “inverted yield curve”, a move that some analysts believe could herald an imminent economic downturn.

The yield on the rate-sensitive two-year Treasury fell below that of its 10-year counterpart on Thursday, after data showed the US private sector added the fewest jobs in three and a half years in August. Bond yields move inversely to prices.

An inverted yield curve — when long-term yields are lower than short-term ones — has historically been seen by some investors as an indicator of a recession, even though it has not always proved accurate. The bond market has been sending this signal almost continuously for the past two years.

However, investors and strategists are split on what the ending of this inversion — driven by investors increasing their bets on rapid interest rate cuts in recent weeks — might mean. While some speculate it could mean better news about the economy, others say it may mean the precise opposite — that a downturn is now imminent.

“It’s tempting to suggest we can sound the all-clear” on the economy but “we’re not out of the woods yet”, said Deutsche Bank strategist Jim Reid. He said that recessions tend to start when the yield curve moves away from being inverted.

“Indeed, the last four recessions only began once the curve was positive again,” he said.

However James Reilly, an economist at Capital Economics, said that while the spread disinverting “has tended to precede recessions in the past . . . this move in yields is a symptom of investors’ worries rather than a new cause for alarm.”

“The Treasury yield curve has steepened in recent weeks amid growing recession concerns, but we doubt one will materialise this time,” he said.

Short-term yields are, historically, usually below longer-term ones, reflecting the higher risks of lending over longer time periods. When short-term loans cost more than long-term ones, it implies investors expect growth — and therefore interest rates — will be lower in the years to come.

Swaps markets are fully expecting a quarter point interest rate cut from their current range of 5.25 to 5.5 per cent at the Fed’s meeting later this month, and additionally are pricing in a 40 per cent chance of a half point cut. They expect just over one percentage point worth of cuts by the end of December.

Labour market data on Wednesday showed that US job openings came in lower than expected for July, triggering the latest sharp rally in short-dated government bonds.

The Job Openings and Labor Turnover figures showed that US job openings fell to 7.7mn in July, its lowest level in three years and lower than economists expected.

The yield on the two-year Treasury note briefly slipped below the 10-year yield’s level on Wednesday before hovering in a tight range just above the “inversion” threshold, as investors expected the figures would keep the Fed on track to lower rates this month.

“At the margin, the JOLTs data does matter,” said Ajay Rajadhyaksha, global chair of research at Barclays. “[The Fed] takes it seriously; they will not shrug it off. The market knows that, and that is why you got that brief un-inversion.”

This is “not so much about the yield curve”, he added “as it is about the front-end rally in anticipation of a quicker cutting cycle”.

Cementing investors’ expectations of looser monetary policy, Fed chair Jay Powell signalled at August’s Jackson Hole economic conference that “the time has come” for US interest rate cuts. He said at the symposium that “downside risks” to the labour market had increased.

The yield curve had already briefly un-inverted early last month, after a much weaker-than-anticipated July payrolls report sparked fears of a looming recession and drove investors to bet on rapid and deep interest rate cuts.

Those concerns were later soothed by a flurry of stronger economic reports, but market participants are watching each data point closely for clues about the future path of US borrowing costs.

Friday will bring the latest non-farm payrolls report, with economists expecting US employers to have added 160,000 jobs in August, according to a Reuters poll — considerably higher than the previous month’s figure of 114,000.

“We think that the front-end might have rallied a bit too far,” Skiba added. “We’ve struggled to see how the Fed cuts more than [one percentage point] here in the absence of economic data getting much worse — but clearly that is where the debate from the market perspective is at this stage.”

Additional reporting by Ray Douglas