One of the most observed artifacts in the global economic and financial spectrum is the US interest rate curve, as it is the best representation of the amount of money lent in the world’s leading power as a function of the duration of the loan. The percentage of these returns (required profitability) of Treasury bonds seems essential to the extent that, in addition to modifying the investments of many operators, they serve as reference when setting interest rates, from mortgages to corporate debtboth in the United States and abroad. The inflationary upheaval caused first by covid and then by the energy crisis derived from the war in Ukraine, accompanied by a strong recovery in the economy, caused sharp increases in interest rates that made the pattern that is emerging during accession with a temporal On the progression line, Treasury yields have been on a downward trajectory since 2022, which, a priori, constitutes an anomaly. Today, two years later and as the Fed is about to start lowering interest rates, this inversion of the curve has ended. It is the closing of an era and the beginning of a new chapter in the global economy that could experience its great prologue this Friday with the official report on American employment for the month of August, a true tuning fork for the movements of the American central bank.
Normally, this pattern that constitutes the yield curve shows an upward slope, because it makes sense that a longer-term bond would offer a higher yield by reflecting greater uncertainty over a longer time horizon. However, the accelerated increases in rates began to change the slope: yields on short-term bonds rose more than those on long-term bonds, because they were more tied to the immediate evolution of interest rates. Bonds already issued and circulating on the secondary market had to offer a higher required yield (cheaper price) to compete with the interest offered on new debt issues.
In other words: the photograph showed high short-term rates to control inflation and more contained rates in the futuregiven that the economic damage from current increases would prompt the central bank to reduce them later. It is this approach that has traditionally made the inversion of the curve an indicator of recession (indeed, what the NBER – National Bureau of Economic Research – in the United States considers a recession). This reversal of the spread between short-term and 10-year bonds has preceded each of the last four US recessions, by a lag of between three and nine months. “The level of US Treasury yields and the changing shape of the Treasury yield curve provide investors with crucial information about the market’s expectations for economic growth, inflation and monetary policy,” say Michael Lebowitz and Lance Roberts, analysts at Real Investment Advice (RIA).
During this economic cycle, the curve has inverted in the section between two and 10 years, the differential (propagated) the most observed, more than 100 basis points (one percentage point), an investment that has not been recorded since the early 1980s and it is precisely now, with fears of recession in the United States that hover over the markets with each piece of data. certifies a certain cooling of the economy, when the inversion of the curve will have ended, with a abrupt disinvestment of 100 basis points in the last two months. On August 5, when the market succumbed after the weak July jobs report, there was already a brief divestment and the propagated turned positive. But it was this week that it became clear that something had changed.
US two- and ten-year rates have been in the 3.75% zone this week, drawing a flat curve, with the two-year yield sometimes falling a few basis points below that of the two-year interest rate. T note (as the 10-year bond is called). On Wednesday, the bigger-than-expected drop in job openings data (JOLTS) for July was the big catalyst. The drop to 7.67 million job openings compared to analysts’ expectations of 8.1 million further reinforced the Fed’s argument that with inflation under control, there is cause for concern about a deteriorating labor market. That sent two-year yields down as much as seven basis points on expectations that the Fed would not be “stingy” with rate cuts, gaining a few more points. a first drop of 50 basis points in September and not 25, as is usually the norm. This Thursday, the weakness of the private employment data from ADP (a net creation of 99,000 jobs against the 144,000 expected) contributed to this dynamic, with the 2 and 10-year bonds falling below 3.75%.
In this context, the employment report that the Bureau of Labor Statistics (BLS) will publish this fridayING’s rate analyst team, led by Padhraic Garvey, confirms that markets are particularly “sensitive” to the “unstable” labor market and will notice this when they see the August non-farm payrolls data.
If the analyst consensus holds true and payrolls hit 165,000 (from 114,000 in July) while the unemployment rate falls another tenth to 4.2%, then the market will price in a cut of just 25 basis points early in the year before the Fed’s easing cycle on September 18. However, analysts such as ING’s US economist James Knightley estimate that payrolls could hit 125,000 and the unemployment rate could hit 4.4%. In that case, the pendulum would swing back to a 50 basis point rate cut in September and the divestment curve would widen.
“As autumn begins to show its first signs of its onset, the yield curve is also heralding a new economic season,” Lebowitz and Roberts write in stone.Initially, the two-year point will be the one that sets the slopeas markets add additional cuts due to the woes of the recession. Once the novelty of the cuts has worn off, it is the return of the term premium that will drive the slope of the curve,” ING analysts add. The “term premium” is the price paid too much for the uncertainty associated with a long term. term as a lender and which justifies that, on paper, longer-duration bonds should yield a higher yield.
ING experts do not want to end their report without issuing a warning: the market is turning the house upside down so much in anticipation of cuts that it is reaching a point where the impact reaction of a cut could well be to raise market rates. a bit, which could cause difficulties for the central bank. “We continue to think that market rates will be lowered as the Fed actually gets on the cutting path, but we also question the degree of maneuver needed to lower market rates substantially,” they say.
“It’s also remarkable that the Fed is about to cut rates at a time when the Dow is just above its all-time high. Yes, there have been some swings this week on the risk side, but not enough to make them look systemic. Something in the bones of the Fed will make them look systemic. It may be a little uncomfortable to lower rates if we continue in this mode risk before the fall occurs. There are still a few weeks to go and we still have to publish Friday’s jobs report, but the Fed has a complex problem to solve here,” they conclude.
For those who criticize the curve’s potential to predict a recession, analysts at BCA Research see it as a late indicator of the onset of a rate cut rather than a “tarot reader” of economic contraction. “This distinction has not made a significant difference in past cycles, as there has been no instance of a rate cut late in the cycle that was not associated with a recession. Rate cuts have come about because of weakening labor demand and rising unemployment, which historically has been associated with a recession,” they argue in a commentary to clients.
“We do not believe this time will be any different. Inflationary pressures are fading, labor demand is weakening, and unemployment is rising, leading policymakers to embark on a new easing cycle. We assign high probabilities to the slope. The slowdown in labor demand is steep enough that the deterioration will result in a recessionary turn in a cyclical period. “We do not subscribe to a soft landing or no landing view and therefore do not consider the fact that the yield curve is returning to positive terrain to indicate that a recession has likely been avoided,” they add.
In its minutes of last year’s July monetary policy meeting, The European Central Bank (ECB) has already warned that market distortions caused by massive bond purchases by central banks make the yield curve not so infallible when it comes to predicting recessions. “Rising short-term rate expectations, combined with overall stability in long-term rates, have deepened the inversion of the euro area yield curve. Coupled with negative surprises in euro area euro data, the inversion has rekindled recession fears among market participants based on empirical evidence that such deep yield curve inversions have a strong track record in predicting recessions,” the central bank minutes said.
“Due to the effect actions “In central banks’ bond holdings, the term premium has remained compressed, which could reduce the predictive content of the slope of the yield curve for economic growth,” European officials said. Invoking the same reason as the ECB, ING analysts focused their fire on the case of the United States: “In practice, the vestiges of the Fed’s past intervention in the bond market continue to suppress the term premium and keep the curve flatter than it would otherwise be.”
For their part, Praveen Korapaty and William Marshall, analysts at Goldman Sachs, theorize that “a large part of the observed reversal in US bond yields does not come from the high probabilities of recession or normalization of inflation, but from the low levels of real rates (nominal interest rates minus inflation expectations) over the long term. “Investors appear to be locked into secular stagnation…the paradigm that has dominated the world over the last cycle.”
Beyond the criticisms and nuances, what is clear is that a new phase between when interest rates began to be lowered, which had to be raised urgently from 0% to 5%, and the forecasts of the ING rate team demonstrate this: “Two- and ten-year rates in the United States have been in the 3.75% range, flattening the curve. And they continue to look down. The five-year note is leading the way, in the 3.55% area. “The final floor is marked by a lower part of the Fed’s rate band around 3%. scenario.”
