Treasury Rally Ignites Debate on How Fast Fed Needs to Cut

(Bloomberg) -- A major rally in the $27 trillion Treasury market is laying bare anxiety that the US economy is sliding into recession and the Federal Reserve will need to start aggressively cutting interest rates.

US government debt surged Monday, pushing two-year yields — which are sensitive to monetary policy — below that of the 10 year note for the first time in two years. That brief normalization offered a vivid indication that growth concerns are fueling expectations for super-sized rate reductions starting in September, or sooner.

“The Fed likely realizes now that they made a mistake last week” by holding borrowing costs steady at a two-decade high, said Campbell Harvey, the economist credited with linking the yield curve with economic growth. The yield curve has normalized — or disinverted — just before the past four recessions, he pointed out, underscoring the case for lower rates. “The Fed has waited too long to take action.”

Bond prices stabilized through the day, with short-term yields ending higher, leaving the curve inverted again as long-term yields fell slightly. Yields rose on Tuesday in Asia trading, further paring losses in previous sessions.

But over the past week, the two-year yield plunged more than 70 basis points to as low as 3.65% on Monday, compared to a peak this year of 5.04% reached in late April. Ten-year yields dropped as low as 3.67%.

Alongside those moves, swaps traders priced in at least five quarter-point Fed rate cuts in 2024, with about 16% probability that the US central bank opts for an emergency reduction before its next scheduled two-day meeting wraps on Sept. 18. Traders who in July made what appeared to be long-shot bets on supersized Fed cuts are now in line to reap huge profits.

The extreme moves Monday were pared after data showed the US services sector expanded in July, helping to allay fresh angst about a broad slowing in the economy.

However, sentiment remains on the fritz after Friday’s increase in the unemployment rate caused its three-month moving average to exceed the 12-month low by half a percentage point. According to the Sahm rule — devised by former Fed economist Claudia Sahm — that means a recession is underway.

Treasuries surged after that jobs report last week, turning into one of the most powerful bond-market rallies since fear of a banking crisis flared in March 2023. The sense in markets is that Chair Jerome Powell and his colleagues are behind on cutting rates.

“The shape of the yield curve is one of several indicators that helps gauge the market’s assessment of recession risks,” said Wei Li, global chief investment strategist at BlackRock. “The recent steepening reflects the market’s assessment that the Federal Reserve is behind the curve and will cut rates more aggressively over the next few years.”

That’s stoking debate around the Fed’s next steps. Citigroup Inc. and JPMorgan Chase & Co. last week predicted the central bank would lower its benchmark by a half-point at both its September and November meetings.

But market pricing indicates an increased chance of a cut even before the Fed’s next scheduled announcement. To Harvey, who is now a finance professor at Duke University and an adviser at Research Affiliates, that would be a signal of “desperation — that the Fed believes the situation is far worse than the market.”

Pressure is on given US financial conditions are at their tightest since October and the intense normalization seen in the yield curve.

The two-year yield had exceeded the 10-year by as much as 111 basis points in March 2023, the biggest inversion since the early 1980s, according to data compiled by Bloomberg. It reached positive 1.5 basis points earlier on Monday before reverting back to being inverted again.

“There is no problem with an inter-meeting Fed cut if financial conditions tighten so much that market liquidity becomes impaired,” said Chris Watling, founder and chief market strategist at Longview Economics. “You will get intervention from the Fed.”

Chicago Fed President Austan Goolsbee reiterated on CNBC the central bank’s job is not to react to one month of weaker labor data, adding markets are much more volatile than Fed actions.

A global rout in equities and the dissolution of a popular strategy in the currency market — dubbed the carry trade — also sent investors into the relative safety of sovereign bonds. Yields on government debt through much of Asia and Europe also fell as stocks in those regions spiraled.

“We are long 2-year Treasuries here and have been for the last few months so that’s protecting us,” said Kellie Wood, head of fixed income at Schroders Plc in Sydney. “We have raised cash, added protection in US credit and bought Treasuries so have some dry powder to re-enter markets if assets really cheapen up.”

For Jerry Cudzil, a generalist portfolio manager in TCW’s Fixed Income Group, the Fed has underestimated just how restrictive policy has been and what it has meant for the consumer.

The move back to a normal curve slope “means you are in a recession,” he said. “At this point, the Fed has made a mistake and policy is too restrictive.”

--With assistance from Alice Gledhill, Anchalee Worrachate and Tania Chen.

(Updates moves and adds comment.)