Bond market signals a swift U.S. economic slowdown isn’t off the table 

Multiple factors appeared to be at play during Tuesday’s session aside from just U.S. growth prospects. One was expectations for a rate cut next year by the European Central Bank. Another is the decision by investors and traders to remove some term premium — or compensation that had been demanded for the risks of holding longer-term debt to maturity and was put into place earlier this year.

The third factor the market is weighing, even if it may not be fully reflected in Tuesday’s moves, is the possibility of an unexpectedly faster U.S. economic slowdown that could morph into a growth scare and undermine expectations for a soft landing, analysts said. The Atlanta Fed’s GDPNow estimate is for a 1.2% real GDP growth rate in the fourth quarter, down from 1.8% last Thursday.

LPL Chief Global Strategist Quincy Krosby said the 10-year yield needs to be watched closely because a faster downward pace of decline would suggest “a growth scare has taken hold.”

The benchmark 10-year rate finished 40.4 basis points below its 2-year counterpart
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keeping the spread between the two yields negative. Ordinarily, the spread should be positive when investors and traders see brighter U.S. prospects ahead. It goes negative when pessimism generally prevails, and the spread has remained inverted since mid-2022.

Tuesday’s move in the curve “doesn’t quite yet suggest a growth scare, which would be accompanied by a more severe flattening of the 2s10s spread,” said Tom Nakamura, a currency strategist and co-head of fixed income at AGF Investments in Toronto, which managed $29.7 billion (CAD $40.3 billion) as of Oct. 31.

“At the end of October, the spread was inverted by around 16 basis points and is now inverted by around 40 basis points, versus more than 100 basis points back in the summer when more Fed hikes were expected to be delivered. We are at the stage where the market is still hoping for a best-of-all-worlds scenario of a soft landing, with growth coming down in a still-healthy manner. The next phase is, ‘do we get more evidence of a soft landing or does this snowball into something more severe like a hard landing?’”

Long-term yields finished at three-month lows on Tuesday as investors weighed a mix of U.S. data that included an update on job openings, which fell to a 28-month low of 8.7 million for October, and an ISM reading on the services sector, which picked up in November. Meanwhile, U.S. stocks
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finished mostly lower.

Tom Graff, chief investment officer at Baltimore-based Facet, which oversees around $2 billion, said Tuesday’s moves reflected some combination of headwinds facing Europe, prompting the need for a 2024 rate cut by the ECB, and term premium that was starting to come out of the U.S. bond market.

In addition, concern in markets “is shifting from solely worrying about inflation to now worrying about whether slowing economic data could continue,” Graff said, citing recent jobs- and manufacturing-linked reports. “I would be pretty concerned if Friday’s jobs data comes in weaker than October’s. A soft landing is the consensus now, but now we need to see if we go from a soft landing to a hard landing.”