Alarm bells: Bond market signal adds to US economy warnings

Stocks are bouncing back from falls caused by weak US economic data but bond and commodity markets remain wary.

Stocks are bouncing back from falls caused by weak US economic data but bond and commodity markets remain wary. Picture: Getty Images

Stocks are rebounding as investors look past US recession fears to CPI data this week that could give the Federal Reserve more room to cut rates without stoking inflation.

But while stock benchmarks in developed markets remain near record highs, industrial commodities including crude oil, copper and oil are down about 20 per cent in recent months.

Bonds also tell a different story, leading analysts to question if stocks can keep shaking off growth worries, particularly after a shaky start to what’s normally the worst month of the year.

After a significant “bull steepening” of the US Treasury yield curve – whereby the entire yield curve has fallen sharply in anticipation of interest rate cuts and slower economic growth – the short-term benchmark has fallen below the long-term benchmark for the first time in years.

Since late April, the 10-year Treasury yield has dropped over 100 basis points to 3.70 per cent, while the two-year yield has fallen 137 basis points to 3.65 per cent.

With US disinflation resuming and the jobs market cooling, the US yield curve has steepened 50 basis points since late June. This week the yield curve officially regained its “normal” positive shape after a historic wait of more than 790 days since January 2022, when US rate hikes were imminent.

The closest previous record was in 1978 and took 624 days. An inverted yield curve for government bonds is usually representative of a “contraction phase” of the business or credit cycle.

Macquarie says financial markets have been “overly obsessed” with this yield curve indicator.

But the fact is a US recession has followed every un-inversion event since 1969.

The S&P 500 has fallen by an average of 34.5 per cent during the eight recessions over that period.

A key question is whether market functioning has normalised enough in the wake of prolonged unconventional monetary policy and stimulus, market dislocations and changes in financial “plumbing” for such yield curve signals to be taken seriously.

Indeed investors are grappling with whether the yield curve un-inversion remains a reliable leading recession indicator alongside other traditional indicators and economic data as many global central banks have already started their easing campaigns to remove restrictive policy while disinflation is largely intact, said Macquarie Private Bank strategists led by Paul Huxford.

“September is historically a seasonally weak month for US equity markets. Shares are at higher risk of further falls as well as other risk asset markets, which may be subject to a period of weaker relative underperformance, elevated volatility and more uncertainty going into US elections.”

September is historically a weak month for stocks. Picture: Getty Images

US high-grade corporate debt markets last week saw their biggest two-day bond issuance volumes going back 20 years as companies looked to avoid volatility and potential credit spread widening from economic data and the uncertainty leading into the US presidential election on November 5.

It does seem as though the powerful US bond market and growth-sensitive industrial commodity markets are priced for a more substantial downturn than most other risk assets including equities.

Current market pricing implies about 107 basis points of easing in the Fed funds rate by year end, 216 basis points by mid-2025 and about 250 basis points of cuts by the end of 2025.

Market pricing also implies a roughly 50 per cent chance that the Fed will kick things off with a jumbo rate cut of 50 basis points versus the normal 25 basis points after its meeting next week.

Macquarie also warns that global economic growth concerns stemming from restrictive monetary policy in most advanced economies comes alongside China’s concerning economic headwinds.

About two-thirds of the OECD countries have had a negative quarter, or worse, of growth already.

If comes as another usually very reliable US recession indicator – the Sahm Rule – was also triggered in early August, although it was potentially hurricane affected and was downplayed by its author.

But alongside the “drum beat of numerous global central banks already easing their policy rates, some for a third time, it is natural to feel some apprehension when observing the strength from risk asset markets, such as US equities”, Macquarie strategists said.

“It continues to be challenging navigating elevated market concentration risk issues for AI/tech and whether the hype continues at this current pace and justifies valuations, against a mixed bag of leading and lagging economic data.”

In that backdrop, Macquarie strategists are vigilant around downside risks, warning that markets remain highly sensitive to economic data geopolitical tensions and election uncertainty.

“Overall, we view market pullbacks as an opportunity for investors to re-examine their portfolios and ensure proper diversification,” Macquarie said. “We retain a constructive view on risk and believe in staying invested via maintaining a balanced portfolio exposure, while also keeping some downside protection and offsets to potential risks that may arise.”