The bond market is about to do something remarkable while Nvidia distracts everyone

While traders were focusing on Nvidia’s results on Thursday, something big was happening in the bond market. The inverted spreading between 2- and 10-year Treasury yields, considered a classic recession indicator, has almost returned to normal.

In Thursday’s trading, the 10 year performance was less than 2 basis points below the 2 year interest ratecapping a reversal that began in June 2022. An inverted curve has been the harbinger of most every U.S. recession since World War II, as it shows traders see long-term growth slowing. (1 basis unit equals 0.01%).

While a recession has yet to occur, the end of the reversal doesn’t necessarily mean we’re out of the woods yet.

In fact, the yield curve generally flattens just before going into recession as traders begin to price in the possibility that the Federal Reserve will have to start cutting interest rates as a way to combat the economic slowdown.

Markets currently widely expect the Fed to begin tapering in September and continue to do so until at least the end of 2025.

While markets closely monitor the relationship between 2-year and 10-year yields, the Fed watches the 10-year compared to the 3-month. As of July, the relationship showed a 56% chance of a recession in the next 12 months, though that probability has fallen, according to the New York Fed.

“The simple explanation behind this relationship is that excessively high Fed Funds rates, which set 3-month Treasury yields, cause recessions. As 10-year yields approximate the market’s best guess of the neutral rate, every whenever the Fed keeps policy rates above these levels the US economy shrinks,” said Nicholas Colas, co-founder of DataTrek Research, in a recent market note. “If this is true, then the US economy is in dire straits recession right now.”

However, Colas also pointed out that recessions generally need some unusual event, such as a spike in the price of oil or a financial crisis. In the absence of a crisis, there was no recession.

“That, however, does not leave the Fed off the hook for a rate cut over the next 12 months, and the markets know that,” he added. “While it may seem aggressive for futures to expect the Fed to cut rates at every meeting next year, it fits with the idea that the Fed should normalize monetary policy in the foreseeable future.”