A sharp reassessment of U.S. interest rate cut expectations is intensifying an already robust bond rally, driven by recent weakening economic data. Investors are increasingly concerned that the Federal Reserve may need to loosen its tight monetary policy more rapidly than anticipated to stave off a recession.
Earlier in the week, investors were contemplating whether the U.S. central bank had delayed too long in shifting to a less restrictive stance when it kept borrowing costs steady at its July meeting. However, by the end of the week, manufacturing data on Thursday and weak employment figures on Friday heightened recession fears and significantly altered the outlook for monetary policy for the remainder of the year.
“The rising unemployment rate indicates that the Fed has fallen behind the curve,” said Tony Farren, managing director at Mischler Financial Group. Futures contracts tied to the Fed’s overnight policy rate now reflect bets on about 120 basis points in interest rate cuts for the rest of the year, nearly double the expectations prior to the Fed’s meeting on Wednesday. This shift led to a sharp decline in Treasury yields, with two-year yields hitting their lowest since March last year and benchmark 10-year yields reaching their lowest since December. The 2/10 yield curve, which has been inverted for more than two years, moved closer to turning positive, a pattern observed in the last four recessions shortly before economic contraction began.
Friday’s data showed the unemployment rate rising to 4.3%, signaling an unexpected decline in the labor market, which had previously shown resilience despite the Fed’s aggressive rate hikes. This increase triggered the Sahm rule, a historically accurate early recession indicator, which is activated when the three-month moving average of the national unemployment rate rises by 0.50 percentage points or more relative to its low in the previous 12 months. On Friday, this indicator rose to 0.53 percentage points.
“This rule is empirical and has never failed,” noted Alfonso Peccatiello, CEO of global macro investment strategy firm The Macro Compass. “Markets are now forced to ask the recession question louder.” The slowdown in July employment came on the heels of a surprise slump in U.S. manufacturing, which had already driven Treasury yields to multi-month lows on Thursday.
“Thursday was the first wake-up call about recession risk, and today there’s another one as people start to believe in the data more,” said Zhiwei Ren, portfolio manager at Penn Mutual Asset Management. “People are rushing into recession trades. We went from ‘Goldilocks’ to recession in one week,” he added, referring to the previously optimistic scenario of lower inflation and stable growth that had buoyed asset prices this year.
However, some market participants urged caution, pointing out that the underlying labor data for July were not as weak as the headline numbers suggested. U.S. bond giant PIMCO noted that while the data strengthened expectations for a first rate cut in September and raised the possibility of a faster pace of cuts, the economy was still holding up. “There were some caveats in the details, which continue to paint a picture of a slowing but not yet crashing economy,” said Tiffany Wilding, managing director and economist at PIMCO.
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