US Bond Market Faces Recession Fears... Fed May Cut Rates as Early as 2024

10-Year to 2-Year Treasury Yield Spread Shrinks Sharply This Year... BOA "Reflects Recession Risk"
Fed Chair Powell "18-Month Short-Term Yield Spread Predicts Recession Risk More Accurately"

Trend of the US 10-Year and 2-Year Treasury Yield Spread

[Asia Economy Reporter Park Byung-hee] This year, the rapid narrowing of the yield spread between long-term and short-term U.S. Treasury bonds is being analyzed as a warning signal of a potential U.S. economic recession. Due to recession risks, the U.S. Federal Reserve (Fed), which raised the benchmark interest rate last week for the first time in about three years, is also expected to cut the benchmark rate again as early as 2024?2025.

The yield spread between the 10-year and 2-year U.S. Treasury bonds has decreased by more than 0.6 percentage points this year. According to Tradeweb, on January 3, the closing yield on the 10-year Treasury was 1.63%, and the 2-year Treasury yield was 0.79%, resulting in a spread of 0.84 percentage points. However, on the 21st, the 10-year Treasury yield was 2.30%, and the 2-year Treasury yield was 2.13%, narrowing the spread to just 0.17 percentage points.

Typically, short-term interest rates respond sensitively to monetary policy, while long-term rates react more to economic conditions. Therefore, an expanding yield spread signals economic expansion, while a narrowing spread indicates economic slowdown.

As the Fed raised the benchmark interest rate for the first time in about three years, short-term rates sensitive to monetary policy rose rapidly, whereas long-term rates, reflecting economic uncertainty, rose less, causing the recent rapid narrowing of the yield spread.

Bank of America (BOA) stated in its report dated the 21st, "Although the Fed anticipated a soft landing for the U.S. economy at last week’s Federal Open Market Committee (FOMC) meeting, the market appears to challenge the Fed’s view," adding, "The recent narrowing of the 2-year to 10-year Treasury yield spread reflects recession risks beyond just a reaction to the Fed’s tightening measures."

BOA also explained that the recent narrowing of the yield spread reflects expectations that the Fed will soon have to lower the benchmark interest rate again to respond to a recession. Based on bond yield movement analysis, BOA forecasted that the U.S. benchmark rate will rise to around 2.25?2.3% by mid-next year, followed by about 2?3 years of economic slowdown, during which the Fed is expected to lower the benchmark rate by 0.5?0.6 percentage points by the end of 2025.

Morgan Stanley predicted in its report dated the 20th that the yield curve could invert in the second quarter. Yield curve inversion between long-term and short-term rates is interpreted as a precursor to a recession within about 6 months to 2 years. Morgan Stanley stated, "Yield curve inversion does not necessarily signal a recession," but added, "It supports our expectation that corporate earnings growth will significantly decline."

Fed Chair Jerome Powell also mentioned the narrowing of the yield spread at the National Association for Business Economics (NABE) meeting on the 21st. However, Powell emphasized that an internal Fed report indicates that the 18-month short-term yield spread is a more accurate predictor of recession than the 2?10 year Treasury yield spread.

Trend of the interest rate difference between the 3-month US Treasury bill and the 18-month forward contract
[Image source= Bloomberg]

Fed economists Eric Engstrom and Steven Sharpe argued in a report published in June 2018 that the short-term Treasury forward spread predicts recessions more accurately than the 2?10 year Treasury yield spread. In that report, they noted that before the last three recessions, the short-term Treasury forward spread inverted, supporting their claim.

Bloomberg reported that the spread between the 3-month Treasury yield and the 18-month forward rate formed in the forward market has widened to 2.29 percentage points, the largest since 2002. This 18-month short-term yield spread, emphasized by Chair Powell, is showing a trend opposite to the narrowing 2?10 year Treasury yield spread.

Powell said, "It is difficult to rationally explain the 2?10 year Treasury yield spread as an economic theory-based predictor of recession risk." However, he added, "We do look at the 2?10 year Treasury yield spread. We cannot say we ignore it. But we tend to focus more on shorter-term yield spreads. It is just one of many indicators we continuously monitor."

This content was produced with the assistance of AI translation services.