US Treasury Yield Curve Suggests Federal Reserve May Wait Too Long Before Resuming Interest Rate Cuts

The US Treasury yield curve has been reflecting growing concerns that the Federal Reserve will delay resuming interest rate cuts as economic growth slows. This trend is particularly evident in the spread between yields of two-year and five-year notes, which has traded at around 3 basis points after briefly turning negative last week for the first time since mid-December.

This part of the curve is significant because durable inversions have preceded major economic contractions and stock market declines for the past 35 to 40 years. According to Tom Fitzpatrick, head of global market insights at R.J. O'Brien, "You've got to pay attention to this curve again because it never got it wrong." These inversions occurred in 1989, 2000, and 2006, each preceding a recession.

Another worrying sign is that benchmark 10-year yields fell back below the fed funds rate last week. The 10-year yields reached 4.12% on Tuesday, while the fed funds rate held steady at 4.33%. Lou Brien, strategist at DRW Trading, noted that this is indicative of the economy essentially saying that the Fed is missing out here. It's behind the curve.

While the curve can invert for different reasons, it often reflects a concern over Fed policy when longer-dated debt yields decline faster than shorter-dated ones. This is because longer-dated yields react to growth fears, while shorter-dated debt yields will reflect Fed interest rate expectations and the possibility that the U.S. central bank will hold rates too high for too long.

The closely watched spread between yields on three-month bills and 10-year notes also reinverted last week for the first time since mid-December. An inversion in this part of the curve is seen as an indicator that a recession is likely in the next 12-to-18 months. The gap between two-year and 10-year yields, another closely watched recession indicator, has flattened back to 25 basis points from a peak of 48 basis points in January but has not reinverted.

Growth Concerns Weigh on Long-End Yields

Longer-dated debt yields have been dragged lower by increasing concerns about U.S. economic growth, in part due to government job layoffs by Elon Musk's Department of Government Efficiency. Uncertainty over the impact of trade tariffs and other government policies is also weighing on consumer sentiment and dampening risk appetite.

Markets have gone from over-exuberance about the economy, which was doing so well, to concerns that activity might fall off a cliff again. According to Jan Nevruzi, U.S. rates strategist at TD Securities, two-year yields are "a little bit more pinned because of the limited reaction function by the Fed." Optimism on Treasury supply has supported the decline in longer-dated debt yields, with the U.S. Treasury maintaining supply levels.

Two-year yields caught up a bit on Tuesday as traders boosted bets that the Fed may cut rates sooner. This came after new tariffs on Mexico and Canada took effect, while levies on Chinese goods increased. Fed funds futures traders are now pricing in a roughly 50/50 chance of a rate cut now in May, with a move not fully priced in until June.

The market wants to price in some greater likelihood of some Fed activity to a greater degree this year, according to Michael Lorizio, head of U.S. rates trading at Manulife Investment Management. To cut rates, however, the Fed will wait to see weakness in several economic metrics.

Jobs Data Key

Clues about whether the United States is facing a more sustained downturn are likely to be in the jobs market, where hiring has slowed though layoffs remain relatively subdued. This could change quickly, as noted by Lou Brien. "When it actually turns, it's going to turn sharply because the layoffs will come."

Friday's jobs report for February is expected to show employers added 160,000 jobs during the month, while the unemployment rate stayed steady at 4.0%, according to economists polled by Reuters. Inflation will also remain a key focus that could keep the Fed on hold for longer if it reaccelerates.

The risk with the Fed is that it will wait too long to cut rates because it is "fighting yesterday's battle," said Tom Fitzpatrick.

Conclusion

In conclusion, the US Treasury yield curve suggests that the Federal Reserve may wait too long before resuming interest rate cuts as economic growth slows. The spread between yields of two-year and five-year notes has traded at around 3 basis points after briefly turning negative last week for the first time since mid-December.

This trend is particularly concerning because durable inversions have preceded major economic contractions and stock market declines for the past 35 to 40 years. The closely watched spread between yields on three-month bills and 10-year notes also reinverted last week, indicating that a recession is likely in the next 12-to-18 months.

The Fed's decision to wait too long to cut rates could lead to further economic downturn, as markets are currently pricing in a roughly 50/50 chance of a rate cut now in May. The jobs market and inflation will remain key areas of focus for the Fed, which may need to reconsider its policy if benchmark 10-year yields drop below the fed funds rate.

The economy is essentially saying that the Fed is missing out here. It's behind the curve. This suggests that the Federal Reserve needs to be more proactive in responding to economic growth concerns and adjust interest rates accordingly to prevent further economic downturn.