Yield Curve Inverts Further on Rising Recession Risk
As the tides of economic fortune ebb and flow, a spectre of recession looms over the horizon, whispering in the rustling of Treasury yields and the shifting sands of macroeconomic indicators.
Recent economic data has painted a complex tableau of financial uncertainty. From declining PMI figures to a palpable deceleration in GDP growth, the economic forecast has shifted, stirring speculations that Fed may be forced to cut rates should the US economy slip into recession.
Uncertainty around the timeline of rate cuts plus a potential looming recession are causing the yield curve to invert once more. Investors can obtain exposure using CME yield futures with a reward to risk ratio of 1.6x.
RECESSION SIGNALS ARE FLASHING AGAIN
Monetary policy winds are starting to shift once more. Recent economic data, including PMI figures, and a sharply weaker GDP in the US have led participants to increase their expectations that the US Federal Reserve (“Fed”) will have to relent and cut rates in 2024.
Over the past month, probability of a rate cut at 7/Nov policy meeting has increased from 42% to 47%. More notably, the probability of a second rate cut at the 18/December policy remains slightly elevated over the past week at 35%.
Typically, rate cuts suggest that the Fed is nearing its dual goals of maximum employment and stable prices. However, current expectations for rate cuts may stem from distinct reasons.
Inflation remains persistent. Fed officials remain steadfast in their battle against inflation. But inflation is stalled at 3%. Higher rates are instead starting to impact economic growth. As rates remain high, the odds of an economic slowdown rise.
On 4/June, job openings in the US fell to their lowest level in three years. On 31/May, the Chicago PMI indicator fell sharply into what is a recession territory.
Q1 GDP was revised lower last month. Weak consumption data from the US has led to expectations that GDP growth during Q2 may remain slow.
On a similar note, the household jobs survey showed full-time employment declining by 625k in May while part-time employment rose by just 286k. However, not all jobs’ data was negative. The establishment jobs survey showed strong job creation at 272k far higher than expectations of 182k. Additionally, wage growth was above expectations as weekly average earnings rose 0.4% compared to 0.2% in April.
The household survey counts each individual only once, regardless of how many jobs they have. In contrast, the establishment survey counts employees multiple times if they appear on more than one payroll.
Many observers have been calling for a recession in the US ever since the Fed raised rates to their highest level in 23 years. Yet the US economy has remained robust. Part of the reason behind the resilience has been the savings cushion that US consumers built up during the pandemic. However, with the strong inflation during the past year, most of that cushion has been spent. Consumers have already started to shift their consumption habits and credit usage (and delinquency) has been on the rise.
Credit card delinquencies are at the highest level in more than a decade and personal savings built up during the pandemic have been exhausted.
ECONOMIC DATA DRIVES BOND YIELDS LOWER AND RE-INVERTS YIELD CURVE
Throughout the past 10 days, economic releases in the US have driven bond yields consistently lower. Recent non-farm payrolls data drove a rally in yields.
Economic releases have also driven a decline in the yield spreads resulting in further inversion of the yield curve. Since the release of the PCE price index and Chicago PMI on Friday 30/May, the 10Y-2Y spread has declined by nine basis points.
The 30Y-2Y spread has performed the worst since then as it stands ten basis points lower.
Further, unlike the uptick in yields following NFP, the yield spreads continued to invert further, especially for the 30Y-2Y and 10Y-2Y spread.
HYPOTHETICAL TRADE SETUP
Historically, the yield spread between 10-year and 2-year Treasuries tends to normalize by the time a recession officially hits the US. Based on current trends, a recession, as indicated by GDP metrics, might not occur until early next year.
Currently, the yield curve is deeply inverted, and recession signals are intensifying. Moreover, the possibility of a rate cut remains uncertain. This ongoing uncertainty about the policy direction is further exacerbating the inversion of the 10Y-2Y spread.
Another factor to consider is the upcoming US elections. As the Fed strives to remain an independent authority, they may opt to avoid major policy moves before elections are concluded.
This week is set to bring several key economic updates, including the May CPI report and the Federal Reserve's revised economic projections. These projections are expected to reveal that rate cuts, previously anticipated for 2024, might be delayed further.
The volatility in economic data has made it challenging to assess the yield trends. Despite a general rise in yields, the yield curve continues to invert, particularly the 30Y-2Y spread, which has been the most adversely affected. This reflects ongoing investor concerns about long-term Treasuries as expectations for rate cuts are pushed further into the future.
Investors can obtain exposure to a further inversion in the 30Y-2Y spread using CME Yield futures. CME Yield futures are quoted directly in yield with a one basis point change in the yield representing a P&L of USD 10.
As yield futures across various maturities represent the same notional, spread P&L calculations are equally intuitive with a one basis point change in the spread between two separate maturities also equal to USD 10.
The hypothetical trade setup using the 30Y-2Y spread is described below.
• Entry: -36.5 basis points (bps)
• Target: -50 bps
• Stop Loss: -28 bps
• Profit at Target: USD 135 (13.5 bps x USD 10)
• Loss at Stop: USD 85 (8.5 bps x USD 10)
• Reward to Risk: 1.59x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Recent economic data has painted a complex tableau of financial uncertainty. From declining PMI figures to a palpable deceleration in GDP growth, the economic forecast has shifted, stirring speculations that Fed may be forced to cut rates should the US economy slip into recession.
Uncertainty around the timeline of rate cuts plus a potential looming recession are causing the yield curve to invert once more. Investors can obtain exposure using CME yield futures with a reward to risk ratio of 1.6x.
RECESSION SIGNALS ARE FLASHING AGAIN
Monetary policy winds are starting to shift once more. Recent economic data, including PMI figures, and a sharply weaker GDP in the US have led participants to increase their expectations that the US Federal Reserve (“Fed”) will have to relent and cut rates in 2024.
Source: CME FedWatch
Over the past month, probability of a rate cut at 7/Nov policy meeting has increased from 42% to 47%. More notably, the probability of a second rate cut at the 18/December policy remains slightly elevated over the past week at 35%.
Typically, rate cuts suggest that the Fed is nearing its dual goals of maximum employment and stable prices. However, current expectations for rate cuts may stem from distinct reasons.
Inflation remains persistent. Fed officials remain steadfast in their battle against inflation. But inflation is stalled at 3%. Higher rates are instead starting to impact economic growth. As rates remain high, the odds of an economic slowdown rise.
On 4/June, job openings in the US fell to their lowest level in three years. On 31/May, the Chicago PMI indicator fell sharply into what is a recession territory.
Q1 GDP was revised lower last month. Weak consumption data from the US has led to expectations that GDP growth during Q2 may remain slow.
On a similar note, the household jobs survey showed full-time employment declining by 625k in May while part-time employment rose by just 286k. However, not all jobs’ data was negative. The establishment jobs survey showed strong job creation at 272k far higher than expectations of 182k. Additionally, wage growth was above expectations as weekly average earnings rose 0.4% compared to 0.2% in April.
The household survey counts each individual only once, regardless of how many jobs they have. In contrast, the establishment survey counts employees multiple times if they appear on more than one payroll.
Many observers have been calling for a recession in the US ever since the Fed raised rates to their highest level in 23 years. Yet the US economy has remained robust. Part of the reason behind the resilience has been the savings cushion that US consumers built up during the pandemic. However, with the strong inflation during the past year, most of that cushion has been spent. Consumers have already started to shift their consumption habits and credit usage (and delinquency) has been on the rise.
Credit card delinquencies are at the highest level in more than a decade and personal savings built up during the pandemic have been exhausted.
ECONOMIC DATA DRIVES BOND YIELDS LOWER AND RE-INVERTS YIELD CURVE
Throughout the past 10 days, economic releases in the US have driven bond yields consistently lower. Recent non-farm payrolls data drove a rally in yields.
Economic releases have also driven a decline in the yield spreads resulting in further inversion of the yield curve. Since the release of the PCE price index and Chicago PMI on Friday 30/May, the 10Y-2Y spread has declined by nine basis points.
The 30Y-2Y spread has performed the worst since then as it stands ten basis points lower.
Further, unlike the uptick in yields following NFP, the yield spreads continued to invert further, especially for the 30Y-2Y and 10Y-2Y spread.
HYPOTHETICAL TRADE SETUP
Historically, the yield spread between 10-year and 2-year Treasuries tends to normalize by the time a recession officially hits the US. Based on current trends, a recession, as indicated by GDP metrics, might not occur until early next year.
Currently, the yield curve is deeply inverted, and recession signals are intensifying. Moreover, the possibility of a rate cut remains uncertain. This ongoing uncertainty about the policy direction is further exacerbating the inversion of the 10Y-2Y spread.
Another factor to consider is the upcoming US elections. As the Fed strives to remain an independent authority, they may opt to avoid major policy moves before elections are concluded.
This week is set to bring several key economic updates, including the May CPI report and the Federal Reserve's revised economic projections. These projections are expected to reveal that rate cuts, previously anticipated for 2024, might be delayed further.
The volatility in economic data has made it challenging to assess the yield trends. Despite a general rise in yields, the yield curve continues to invert, particularly the 30Y-2Y spread, which has been the most adversely affected. This reflects ongoing investor concerns about long-term Treasuries as expectations for rate cuts are pushed further into the future.
Source: CME CurveWatch
Investors can obtain exposure to a further inversion in the 30Y-2Y spread using CME Yield futures. CME Yield futures are quoted directly in yield with a one basis point change in the yield representing a P&L of USD 10.
As yield futures across various maturities represent the same notional, spread P&L calculations are equally intuitive with a one basis point change in the spread between two separate maturities also equal to USD 10.
The hypothetical trade setup using the 30Y-2Y spread is described below.
• Entry: -36.5 basis points (bps)
• Target: -50 bps
• Stop Loss: -28 bps
• Profit at Target: USD 135 (13.5 bps x USD 10)
• Loss at Stop: USD 85 (8.5 bps x USD 10)
• Reward to Risk: 1.59x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
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