Nicholas Colas, co-founder of DataTrek, said that the long-term relationship between the 2-year and 10-year US bond yields is not the only recession warning signal sent by the bond market last Friday.

The sharp drop in the 2-year US bond yield has also pushed the spread between short-term notes and the federal funds rate to its most negative level in at least 50 years. Colas pointed out that during this period, the spread between these two short-term interest rates has only fallen below -1% three times. Each time this happened, an economic recession began within a year.

However, Colas does not believe that this will necessarily lead to an economic recession. He said that an economic recession needs a catalyst to start, and so far, the US has not experienced anything that could trigger such a severe economic slowdown.

On the contrary, this inversion indicates that bond traders are increasingly worried that the Fed has not been quick enough to lower borrowing costs in the face of a slowing labor market.

Colas said in a report on Monday: "The US bond market is saying that the Fed is far behind the curve in cutting rates."

Powell and other senior officials have suggested that the Fed will cut interest rates for the first time later this month since the early days of the COVID-19 pandemic.

Investors often see the bond market as a barometer of economic health. Last Friday, the spread between the 2-year US bond yield and the 10-year US bond yield turned positive for the first time in over two years, ending the longest period since the late 1970s of short-term interest rates being higher than long-term rates.

Historically, the inversion of the US bond yield curve has been a reliable indicator of an upcoming economic recession. However, the widely predicted economic downturn on Wall Street at the end of 2022 has not yet materialized. This does not mean it will not happen. Some bond traders argue that when the US bond yield curve returns to positive territory, it is often the last step before the economy begins to contract.

Last week, concerns about the slow action of the Federal Reserve were not limited to the bond market, as the S&P 500 index also recorded its largest drop since the collapse of Silicon Valley Bank.

Colas is not the only one to notice the significant drop in the 2-year US bond yield as a key development in the market. Renaissance Macro's Jeff deGraaf pointed out that the difference between the 4-week moving average of the 2-year US bond yield and the federal funds rate fell to its lowest level since 2008 last Friday.

Like Colas, deGraaf is also hesitant to interpret it as a certain signal of a recession. However, he warned that this is not the only market indicator forecasting trouble ahead.

deGraaf stated in his report: "The spread between the 2-year US bond yield and the federal funds rate is now approaching the levels seen in 2008, during the last balance sheet recession. Although it does not appear to be a balance sheet recession yet, credit spreads are starting to widen, and at the same time, the yen is strengthening, both signs of liquidity drain."

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