Treasury Yields Sink Further as Recession Risks Rise

The bond market is sending a clear message: recession risks are rising. Treasury yields have been falling for six consecutive weeks, with 10-year yields hitting the lowest level since December. This is a stark contrast to the strong economic data and high inflation expectations that have been reported recently. So, what's driving this divergence?

The answer lies in the bond market's focus on long-term prospects rather than short-term inflation concerns. Government policies that impose trade barriers and limit immigration have the potential to raise inflation in the short run and slow growth in the long run. The bond market has decided to bypass short-term inflation concerns and focus on the long-term prospects. As a result, the yield curve has inverted again with the fed funds rate higher than yields for all maturities.



The economic data isn't pointing to a recession yet, but there are warning signs of a growth slowdown. Fourth-quarter GDP growth came in at a healthy 2.3% pace, driven primarily by consumer spending. However, the early data for this year suggest a slowdown is in the making. The Philadelphia Federal Reserve's Manufacturing Business Outlook Survey results show that new orders and hiring are down while prices are up. This downturn in activity is consistent with other reserve bank findings and reflects a recent downturn in activity.

Real personal spending showed a steep drop in January after a year of monthly gains. Lousy weather in much of the country may have contributed to the decline, but it was much weaker than expected and is an indicator that bears watching. The January unemployment report should provide some insight. To date, the job market has remained healthy, with the unemployment rate remaining low near 4% and job growth surprising on the upside. Under the surface, however, job openings and the pace of hiring have slowed. Those trends have been offset by a relatively sluggish pace of layoffs. The federal government layoffs won't likely show up in the data right away, but it may be hanging over the market and consumer sentiment. It's worth noting that for every federal government worker, there are an estimated two contractors in the labor market. Contractors often are the first to be laid off. An uptick in weekly initial jobless claims during the week ending February 22nd may just be a fluke but if the trend continues, it would be a signal of a slowdown.

Inflation is still too high for the Fed to consider another rate cut. The recent Personal Consumption Expenditures (PCE) price index report for January indicated some easing in pressures, but at 2.5% for overall PCE and 2.6% for core PCE (excluding volatile food and energy prices), inflation is still too high for the Fed to consider another rate cut. Moreover, with the tariffs on goods from Mexico, China, and Canada, inflation risk is likely to revive. These countries are major U.S. trading partners. Consequently, there is a lot at stake for the economy. There is a lot at stake for the Federal Reserve, as well. Inflation is too high and the outlook too uncertain for easing policy, but slower growth longer term could warrant it. No one at the Fed is arguing for it to abandon the 2% inflation target. It has been in place since the 1990s and is the standard for most major developed market central banks. With so many factors at odds, all the Fed can do is wait to see what happens next.

In summary, while GDP growth and unemployment rates suggest a relatively stable economy, other indicators such as the Philadelphia Federal Reserve's Manufacturing Business Outlook Survey results, the drop in real personal spending, and the uptick in weekly initial jobless claims point to potential slowdowns. This mixed picture aligns with the market's perception of rising recession risks, as reflected in the falling Treasury yields. The bond market's focus on long-term prospects and the Federal Reserve's policy of keeping interest rates on hold are driving the inversion of the yield curve. These factors may influence the Fed's future policy decisions, with the Fed likely to continue monitoring economic data closely and being cautious about easing monetary policy until there is more clarity about the economic outlook.