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The bond market is trying to push the Fed into a new rate-cutting cycle

Javier E. David
Editor focused on markets and the economy

Plunging Treasury yields are stoking new fears about an economic slowdown, or—depending on which part of the interest rate curve is being scrutinized—an outright recession.

An inverted yield curve — in which rates on short term debt overtake longer-dated paper — temporarily upended markets earlier this year. Over the last month, the turmoil has reasserted itself in stocks as the U.S. and China dig in their heels in a bilateral trade dispute, sparking concerns over a global slowdown.

With the 10-year Treasury yield sinking to its lowest in nearly 2 years below 2.3%, and President Donald Trump threatening to slap tariffs on Mexican imports, economists are split on whether bond investors are reacting to headlines, or fearful of an impending recession.

Yet some think markets may have an ulterior motive: To force a studiously neutral Federal Reserve off the fence, and into a new rate-cutting cycle.

“Treasuries are rallying not because of Fed action, but because people are concerned about trade war escalation” and weaker growth worldwide, said Eric Stein, co-director of global income and a portfolio manager at Eaton Vance, which has more than $493 billion in assets under management.

The Fed meted out its last interest rate hike last December, and has been on hold ever since.

Nevertheless, “the markets are pricing in a significant probability of a fed cutting cycle,” Stein said — an unlikely scenario for now, given a robust jobs market and U.S. growth that checked in above 3% in the first quarter.

‘Kicking and screaming’ into a rate cut

Fragile sentiment and fears of the U.S.-China trade dispute cascading across the global economy has sent investors scrambling to the relative safe-haven of bonds.

That shift picked up speed on Friday, as stock markets convulsed in reaction to Trump threatening Mexico for not doing more to stop the flow of migrants streaming across the border.

Year-to-date, investors have plowed $236 billion into bond funds, while shifting $121 billion out of equities as the S&P 500 (^GSPC) the Dow (^DJI) and the Nasdaq (^IXIC) have tumbled sharply, according to Deutsche Bank data.

Although the Fed has not suggested an imminent rate cut — a move demanded by Trump to help him prevail in the Sino-American trade war — the central bank is certainly paying attention.

On Thursday, Vice Chairman Richard Clarida said the central bank thought the economy was in “a good place,” but could cut benchmark rates if growth slowed sharply.

Richard Clarida, vice chairman of the U.S. Federal Reserve. Photographer: Andrew Harrer/Bloomberg via Getty Images

“The Fed may think they have rates in a good place, but the world is not in a good place,” warned Chris Rupkey, chief financial economist at MUFG Union Bank, who said Trump risked “turn [ing] the world upside down” with his threats of tariffs against major U.S. partners.

“Fed officials are going to be [dragged] kicking and screaming into a rate cut if downside economic risks start to mount from this latest broadside from the Trump administration,” he said.

“By cutting rates they are playing into the president's hands by providing support for the economy while the president tries to turn the tables on America's trading partners and risks turning the world economy upside down.”

Will the Fed take the bait?

Adding fuel to the calls for a Fed cut is curiously low inflation. With prices comfortably below the Fed’s target of 2%, it would give the central bank latitude to ease policy.

“The Fed does care about markets, they care about financial conditions,” Stein said. “The tighter financial conditions are the more likely the Fed is going to act.”

Lower bond yields aren’t all bad, as they drag down consumer borrowing costs across the spectrum—including mortgage rates, which hit their lowest level in over a year this week.

However, low rates also mean banks become more reluctant to lend, amid lower returns.

Investors demanding higher rates in the short term “are telling us one thing: Unless the Fed cuts rates soon, we run the risk of a deceleration in credit growth and a potential recession,” said

Alessio de Longis, senior portfolio manager, global multi asset, at Invesco, which oversees over $1 trillion in assets.

“If the yield curve stays flat or inverted, you disincentivize the basic principle of credit creation,” he added.

Currently, de Longis thinks there’s a 30% chance the Fed will cut rates at least once by the end of the year, provided the trade war becomes a drag on global growth and stocks contain their losses.

“What we have seen so far is not enough to put a Fed (cut) on the table,” he said. However, should stocks shed another 10-15% from current levels, the chances of another easing cycle will rise “quickly” to 50% by year’s end, he added.

For JP Morgan economist Michael Feroli, Trump’s latest shot at Mexico is enough to warrant rate cuts this year.

“If the Administration follows through on the proposed actions, we believe the adverse growth implications would prompt Fed easing,” Feroli said on Friday.

“Even if a deal is quickly reached with Mexico, which seems plausible, the damage to business confidence could be lasting, with consequences that might still require a Fed response,” he added. “Accordingly, we now look for two 25bp reductions in the federal funds rate target, in September and December.”

Javier is an editor for Yahoo Finance. Follow Javier on Twitter: @TeflonGeek

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