A key part of the U.S. Treasury yield curve briefly turned positive recently, which typically signals an improvement in economic prospects. Behind this change is the market's expectation of larger interest rate cuts by the Federal Reserve, driven by the latest weaker-than-expected labor market data.

On Wednesday, local time, U.S. Treasury prices rose significantly, especially for short-term bonds that are more sensitive to Federal Reserve monetary policy. This rise was fueled by a drop in job vacancies in the U.S. to the lowest level since early 2021. This data caused the two-year Treasury yield to fall below the 10-year yield for the second time since 2022, as traders increased bets on a large interest rate cut by the Federal Reserve this month.

John Fath, Managing Partner at BTG Pactual Asset Management US LLC, pointed out that the Federal Reserve may need to take action earlier, perhaps even raising rates by 50 basis points. If this prediction comes true, the yield curve may experience a complete reversal.

Market participants are increasing their bets on a significant interest rate cut by the Federal Reserve at the September meeting. The interest rate swap market shows that traders have fully incorporated the expectation of a 25-basis-point rate cut by the Federal Reserve this month, and there is over a 30% chance that the rate cut will be 50 basis points. In addition, it is expected that the remaining three policy meetings this year will result in a total of 110 basis points of rate cuts.

Economists and fund managers on Wall Street are closely watching economic data for signs of weakness that could prompt the Federal Reserve to initiate a significant interest rate cut cycle. The job data on Wednesday suggests that weakness in the labor market may prompt Fed officials to take action.

Earl Davis, Head of Fixed Income at BMO Global Asset Management, believes that the weakness in the labor market lowers the threshold for the Federal Reserve to cut rates by 50 basis points later this month. He pointed out that once the Fed starts cutting rates, it is unlikely to be a one-time move because they have enough room for rate cuts.

The yield curve is tending towards normal.

As traders' expectations of a rate cut by the Federal Reserve strengthen, the volatility of US interest rate expectations indicators is also significantly increasing. Although historically the yield curve of bonds tends to slope upwards, in March 2022, as the Federal Reserve launched its most aggressive tightening cycle in decades, the yield curve inverted. However, with the Federal Reserve starting to cut rates, the yield curve may return to a normal upward trend after a prolonged inversion.

On Wednesday, the yield of two-year US Treasury bonds saw a significant decline and closed at 3.754%, slightly lower than the yield of ten-year Treasury bonds at 3.755% during the same period. This small gap indicates that the yield curve of Treasury bonds is exhibiting an extremely slight inversion.

Although an inverted yield curve is often seen as a sign of an economic recession, strategists and some Federal Reserve officials have been skeptical about this in recent years. They believe that the recession signal conveyed by the yield curve inversion may be distorted due to the Federal Reserve keeping rates at extremely low levels.

Jerome Schneider, the head of short-term portfolio management and funding at Pacific Investment Management Company, stated that a normal yield curve shape indicates a more normal and balanced environment for business and monetary policy. Simon White, a Bloomberg macro strategist, also pointed out the unreliability of the recession signal from the inverted yield curve, indicating that it does not necessarily indicate an upcoming economic recession.

Priya Misra, a portfolio manager at JPMorgan Asset Management, also believes that the inversion of the yield curve is meaningful as the Federal Reserve begins to cut rates. She added that the degree of market pricing easing aligns with the expectation of the Federal Reserve to achieve rate normalization to maintain the current soft landing of the economy.

Federal Reserve Chairman Jerome Powell explicitly stated in his speech at Jackson Hole that he intends to prevent further cooling of the labor market and believes that it is time for the central bank to lower key policy rates. Market participants are waiting for the US labor report to be released on Friday, which could be a key factor in whether the Federal Reserve chooses to cut rates by a significant 50 basis points rather than a gradual 25 basis points.

Steven Zeng, the US rate strategist at Deutsche Bank, stated that Friday's employment data will be the "main factor" determining the Federal Reserve's rate cut decision.

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