Over the past two years, the U.S. Treasury yield curve has briefly inverted for the second time, potentially signaling a recession?

On Wednesday, September 4th, after the release of data showing that the job openings in the US in July fell to a three-and-a-half-year low, evidence of a weak labor market prompted traders to increase their bets on a significant rate cut by the Federal Reserve. This also led to a sharp drop in the yields of US short-term bonds, which are more sensitive to interest rates.

The two-year US Treasury yield briefly fell by more than 11 basis points to 3.774%, hitting a new low of over a year since the end of April last year. The 10-year benchmark bond yield, considered as the "anchor of asset pricing," plunged the most by 7.5 basis points to 3.768%, reaching a two-week low since August 21st.

However, amidst the decline in yields, the yield curve of the two-year and 10-year US Treasury bonds, which serve as leading indicators for the economy, briefly ended its inversion, marking the second occurrence since June 2022. The last time this happened was during the market turmoil on August 5th. In other words, for the second time in two years, the 10-year US Treasury yield briefly exceeded the two-year short-term bond yield.

According to Dow Jones market data, since July 1, 2022, there has not been a long-term bond yield higher than the short-term bond yield at the close of trading, and once this happens, it will end the longest period of yield curve inversion on record. As of this Tuesday, the curve has been inverted for 543 consecutive trading days.

Weak labor data fuels bets on Fed rate cuts, leading to a brief end to the yield curve inversion

Typically, an inverted key US Treasury yield curve is a precursor to an economic recession. In March 2022, as the Federal Reserve embarked on its most aggressive tightening cycle in decades, the yield curve inverted. In March 2023, the two-year US Treasury yield was briefly 111 basis points higher than the 10-year yield, marking the largest inversion since the early 1980s.

Some analysts point out that the reason for shorter-term bond yields being higher than longer-term yields, i.e., an inverted curve, since World War II is essentially traders pricing in expectations of future economic slowdown. Otherwise, the uncertainty of holding longer-term bonds should demand higher yields from them:

"Therefore, the improvement in the yield curve inversion tells us that even in the event of a brief economic downturn, with the Fed cutting rates starting this fall, the economy is likely to stabilize in the long term and resume growth.

Expectations of the Fed announcing rate cuts after the FOMC meeting on September 18 are pushing down short-term bond yields, while expectations of strong long-term economic growth and inflation are suppressing the decline in the 10-year Treasury yield."

John Fath, Managing Partner at BTG Pactual Asset Management US, stated that if the Fed indeed cuts rates significantly by 50 basis points, the crucial two-year/10-year Treasury yield curve may completely end its inversion. Priya Misra, Portfolio Manager at JP Morgan Asset Management, also believes that as the Fed is about to start cutting rates, it is very reasonable for the yield curve inversion to end In combination with this year's dovish comments supporting an immediate rate cut by the Atlanta Fed President Bostic, on Wednesday, the US short-term interest rate futures indicated that the possibility of a 50 basis point rate cut by the Fed in September was higher than the traditional 25 basis point cut. Traders also further increased their bets on the Fed's rate cuts by a total of 107 basis points in the remaining three meetings this year.

Earl Davis, head of fixed income at BMO Global Asset Management, also stated that the significant evidence of weakness in the US labor market "lowers the threshold for the Fed to make a large 50 basis point rate cut in September," and once the Fed starts a single 50 basis point rate cut, "it won't be a one-time event, they have enough room to cut."

However, historically, when the yield curve inverts, it signals economic problems, which may not be entirely positive for the stock market

Nevertheless, many analysts point out that although the long-term inversion of the US bond yield curve usually occurs when the Fed begins cutting rates, as the Fed often eases policy only when the economy faces difficulties, the inversion of the yield curve may actually exacerbate investors' concerns about an economic recession, which is also a negative signal for the stock market.

Quincy Krosby, Chief Global Strategist at LPL Financial, noted that statistically, the normalization of the US bond yield curve (i.e., the end of inversion) either indicates that the economy is indeed entering a recession or that the Fed is about to cut rates to address economic slowdown.

This suggests that the normalization of the curve does not necessarily signal better days ahead, but rather indicates that the US may still face some challenging economic conditions. Moreover, the spread between the most closely watched 3-month/10-year US Treasury yield curve remains severely inverted, exceeding 130 basis points.

However, Barron's view is that the recent end of the yield curve inversion is historically positive for the US stock market. Since 1980, in the 12 months following the first end of a yield curve inversion, the average return of the S&P 500 index was as high as 12.2%.

After the six instances of yield curve inversions ending during this period, the S&P index rose four times, each time achieving double-digit percentage gains within a year. There were two instances of declines, one of which occurred when the yield curve inverted in 2007, shortly before the outbreak of the 2008-2009 financial crisis:

This year, the market's performance may be more similar to that of 1989, when the economic recession occurred after the end of the US bond yield curve inversion. Even if the economy now enters the "mild and short-lived" recession expected by the market, the stock market may remain unscathed.

The current hope is that the federal funds rate is unlikely to rise further, as the inflation rate has halved from its peak, which means that even if economic growth slows, it will not decline too much.

Consumers and businesses will have more spending power, allowing corporate earnings to continue to grow. At the same time, lower rates will reduce the attractiveness of bonds relative to stocks, potentially channeling more funds into the stock market