Investors brace for economic slowdown as Fed indicator flashes warning, raising fears of weaker growth
A closely watched recession indicator used by the US Federal Reserve has resurfaced in the US bond market, according to CNBC.
On Wednesday, the US 10-year Treasury yield fell below the 3-month note, forming an “inverted yield curve.” This pattern has historically signaled economic downturns within 12 to 18 months.
The New York Fed tracks this measure closely, publishing monthly updates that estimate the likelihood of a recession.
At the end of January, when the 10-year yield was 0.31 percentage points above the 3-month, the recession probability stood at 23 percent.
However, the recent shift in February suggests that percentage will rise. The inversion reflects expectations that the Fed will lower short-term interest rates in response to a slowing economy.
“This is what one would expect if investors are adopting a much more risk-averse attitude set of behavior due to a growth scare, which one periodically sees late in business cycles,” said Joseph Brusuelas, chief economist at RSM.
He noted that it remains uncertain whether this signals a pronounced economic slowdown or just market noise.
Although markets often track the 10-year/2-year Treasury spread, the Fed prefers the 10-year/3-month relationship because it is more directly influenced by its federal funds rate.
While the 10-year/2-year spread remains slightly positive, it has flattened significantly in recent weeks. However, inverted yield curves have not always perfectly predicted recessions.
The last inversion occurred in October 2022, yet the US has not entered a recession more than two years later.
Economic concerns under Trump administration
Following the US presidential election on November 5, 2024, the 10-year Treasury yield surged, reflecting investor expectations of stronger economic growth under US President Donald Trump.
However, some analysts also saw it as a response to inflation concerns and the growing US debt and deficit.
The yield peaked just before Trump’s inauguration on January 20, but since then, it has dropped by 32 basis points as investors worry about the impact of his trade policies.
“What’s happening is all the uncertainty around the tariffs in particular is putting a very high-powered magnifying glass over all those cracks,” said Tom Porcelli, chief US economist at PGIM Fixed Income.
He noted that concerns over tariffs could intensify inflation and slow economic growth.
Recent surveys indicate growing consumer and investor anxiety about a potential economic slowdown.
The University of Michigan’s monthly survey reported that long-term inflation expectations, looking five years ahead, have reached their highest level since 1995.
Additionally, the Conference Board’s expectations index for February dropped to levels historically associated with recessions.
Despite these concerns, key economic indicators such as consumer spending and employment remain stable.
“We are not looking for a recession,” Porcelli said. “We don't expect one. We do, however, expect softer economic activity in the coming year.”
Market sentiment appears to align with this view. Traders are now anticipating at least a half percentage point cut in interest rates by the Fed this year, according to the CME Group’s FedWatch tool.
The bond market “smells recession in the air,” said Chris Rupkey, chief economist at FWDBONDS.
Still, Rupkey remains uncertain about whether the US will enter a recession, as the labour market has not yet shown significant weakness.
“The yield curve inversion is a pure play on the economy being not as strong as people thought it was going to be at the beginning of the Trump administration,” he said.
“Whether or not we're forecasting a full-blown recession, I don't know. You need job losses for a recession, so we're missing one key point of the data.”
In February, according to Market Watch, bonds have outperformed US stocks, with the iShares Core US Aggregate Bond ETF gaining 1.8 percent and the S&P 500 falling 1.4 percent.
However, relying on long-term bonds for portfolio cushioning is risky due to their sensitivity to inflation, which remains above the Federal Reserve's 2 percent target.
Rick Rieder from BlackRock suggests focusing on shorter-duration bonds for stability amidst economic uncertainty.
Additionally, the Federal Reserve is considering pausing or slowing down the quantitative tightening process, which could temporarily calm bond markets concerned about fiscal uncertainties.
Treasury Secretary Scott Bessent has assured that there are no immediate plans to increase long-term debt issuance.
Despite this, the market still expects government debt to rise due to anticipated tax cuts proposed by US President Donald Trump, which could increase deficits, according to Reuters.
