Economic fears send yields to one-year lows, 2/10 curve turns positive

US. Treasury yields dropped to more than one-year lows on Monday and a closely watched part of the Treasury yield curve turned positive for the first time in two years on increasing concerns that the United States may be heading into a recession.

The yields came off their lows, however, after data on Monday showed that U.S. services sector activity rebounded from a four-year low in July amid a rise in orders and employment.

An unexpected increase in the employment rate and fewer than expected job gains in July’s employment report on Friday sparked a rapid repricing of expectations on when and how far the Federal Reserve will cut interest rates.

The U.S. central bank is now seen as possibly cutting interest rates before its next scheduled meeting in September, or making a larger cut then to stave off a severe economic downturn.

"There is more convincing evidence that there could be more potentially negative ramifications from the Fed being as restrictive as it was for as long as it has been," said Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets in New York.

The Fed has been hesitant to cut rates as inflation eases steadily but remains above the central bank's 2% annual target. Fed Chair Jerome Powell said on Wednesday rates could be cut as soon as September if the U.S. economy follows its expected path.

But now, "conversations about an inter-meeting rate cut have picked up," Lyngen said. "I think the biggest debate is whether or not they go 25 or 50 (basis points) in September."

Traders now see a cut of 50 basis points in September as almost certain, according to the CME Group's FedWatch Tool. That was seen as only having 11% odds a week ago. In total, 121 basis points of easing is priced in by year-end.

Chicago Federal Reserve Bank President Austan Goolsbee on Monday said while the U.S. employment data on Friday was weaker than expected, it does not look like a recession, but that Fed officials need to be cognizant of changes in the environment to avoid being too restrictive with interest rates.

Yields on interest rate sensitive two-year notes were last down 1 basis point at 3.8626% and got as low as 3.654%, the lowest since April 2023.

Benchmark 10-year note yields fell 2.3 basis points to 3.773% to 3.684% and reached 3.667%, the lowest since June 2023.

The gap between two- and 10-year Treasury notes was last at minus 9 basis points, after earlier reaching 1.50 basis points. It is the first time it has turned positive since July 2022.

An inversion in this part of the yield curve typically indicates that a recession is likely in the next one-to-two years, though this inversion has lasted longer than in previous episodes.

The curve usually turns positive before a downturn begins.

"It depends on the August payroll number, if it’s similarly weak (to July) then there’s a good case for a bigger cut,” said Jim Caron, CIO, cross-asset solutions at Morgan Stanley Investment Management.

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