Evidence that the slowdown in economic activity may ease inflationary pressures pushed down US Treasury yields for a fourth consecutive trading day on Tuesday. For most of 2024, this phenomenon will be seen as good news by stock investors as it relieves the pressure on the Federal Reserve to maintain interest rates at their highest level in 23 years.

However, the bond market seems to be undergoing a subtle shift, with the focus now on whether the Fed needs to lower borrowing costs to support the economy. If the Fed is ultimately forced to cut rates because the economy is showing cracks, stock investors may not be so happy.

This is in sharp contrast to just a week ago, when the rise in US Treasury yields shook the stock market and traders feared that policy makers might need several more months of positive inflation data to lower the Fed's benchmark interest rate target from its current range of 5.25% to 5.5%.

John Farawell, Executive Vice President of Roosevelt & Cross, a New York municipal bond underwriter and head of municipal trading, said: 'The market is starting to lean towards the Fed starting to cut rates sooner. It's like we thought the economy was having some kind of soft landing, but now we're back to where the Fed might need to reach out to help.'

The latest economic data released on Monday and Tuesday also underscored this point. On Monday, the May Purchasing Managers Index (PMI) for manufacturing, released by the Institute of Supply Management (ISM), fell to 48.7%, lower than the expected 49.6%, due to a stagnation in economic activity. On Tuesday, there was also news that the number of job vacancies in the US in April fell to 8.1 million, lower than economists' expectations, indicating a cooling in the labor market.

Although these data are not enough to clearly indicate an impending economic downturn, the bond market on Tuesday rekindled the realization that any slowdown in the economy could be serious enough to require the Fed to take rate cuts within months.

The FedWatch tool from the Chicago Mercantile Exchange showed that the likelihood of futures traders in federal funds reducing rates by at least 25 basis points in September rose to 65.7%, up from 59.6% the previous day. At the same time, according to Bloomberg News, swaps trading reflects a higher probability of the Fed cutting rates since November.

"The downward trend in US Treasury yields over the past few trading days is a response to a series of data showing that the economy is indeed cooling," said Chip Hughey, Managing Director of the Fixed Income Division at Truist Advisory Services in Virginia. He pointed out, "The drop in job vacancies to the lowest level in three years, coupled with earlier data showing sluggishness in housing, spending and manufacturing activity, appears to indicate that the impact of the Fed's historic tightening cycle is slowly becoming apparent."

Although the Fed would like to see more sustainable evidence of anti-inflation, Hughey wrote in an email, "If recent economic trends continue, this will be consistent with the expectation that the Fed will not raise rates further but will begin cutting rates later this year." He believes, "The drop in US Treasury yields is a recalibration of the possibility that this will happen. We still expect the Fed to start cutting rates at its FOMC meeting in September."

On Tuesday, yields on 2-year, 10-year, and 30-year US Treasuries fell for the fourth consecutive trading day. Yields on 10-year and 30-year US Treasuries closed at 4.335% and 4.483%, respectively, the lowest level in two months, and the biggest four-day drop since February 1. It is worth noting that the trend in long-term bond yields often reflects a broader view of the bond market on the economic outlook.

The simultaneous drop in short-term bond yields sends a signal about short-term interest rates, indicating that the Fed may need to begin lowering rates. The two-year US Treasury yield, which is sensitive to policy, fell to 4.77% on Tuesday, marking its biggest four-day drop since May 6.

Editor/Emily