What a 10-year Treasury yield above 4% says about the economy

By Vivien Lou Chen

Rising yields are being viewed through improving chances of a 'no-landing' outcome in the U.S.

Bond traders began the week by continuing to sell U.S. government debt as Friday's outsized job gains for September continued to sink in and a brighter outlook pushed the benchmark 10-year yield slightly above the level synonymous with a healthy economy.

The 10-year yield BX:TMUBMUSD10Y rose above 4% for the first time since July-August on Monday, after finishing on Friday with its biggest weekly gain since October 2023. Meanwhile, the policy-sensitive 2-year rate BX:TMUBMUSD02Y also briefly broke above the 4% level on Monday as fed-fund futures traders priced in a slight chance of no interest-rate cut by the Federal Reserve next month.

Monday's broad-based rise in yields was being seen through the lens of economic strength after September's shocking 254,000 nonfarm payroll gains, and the need to reassess the neutral rate of interest or level at which interest rates are neither accommodative nor restrictive. Financial-market participants were embracing not just the possibility of a soft landing, in which the U.S. is able to dodge a recession as inflation eases, but the prospect that the economy could keep expanding.

Read: Stock market's soft-landing rally faces CPI inflation test. Here's what investors should do.

"The prospects for a 'no landing' outcome as it relates to the U.S. economy have improved following the strong payrolls report and it follows intuitively that investors have materially scaled back near-term Fed cut expectations," said BMO Capital Markets strategists Ian Lyngen and Vail Hartman.

The most relevant change in the way in which market participants are thinking about the path of interest rates "has involved expectations for the pace of Fed cuts," they wrote in a note. "The assumption that it will be a steady, predictable march back to neutral has been abandoned in favor of expectations for there to be a pause somewhere during the normalization process."

On Monday, the market-implied probability of a pause or no action by the Fed in November - which would keep the fed-funds rate target at a current level between 4.75% and 5% - jumped to as high as 18.5% versus 2.6% on Friday. Traders were still mostly pricing in a 25-basis-point cut each in November and December.

Monday's market moves were the opposite of what was occurring just a few months ago, when the labor market looked to be weakening.

On Aug. 2, nonfarm payrolls grew by a paltry 114,000 for July and the unemployment rate hit an almost three-year high of 4.3%. The weak jobs data fanned recession fears and, in a matter of days, sent the 10-year yield down to 3.782% - its lowest closing level since July 2023. The market-implied chance of a 50-basis-point rate cut for September also jumped.

The following chart provided by Ben Emons, chief investment officer and founder of Fed Watch Advisors in Washington, shows how much has changed. Now, September's strong jobs data has dramatically reduced the likelihood of a 50-basis-point cut, as reflected by the blue line, while lifting the 10-year yield, as the orange line shows.

As of Monday morning, Treasury yields were broadly higher, led by spikes in the 1-month BX:TMUBMUSD01M and 2-year rates BX:TMUBMUSD02Y. All three major U.S. stock indexes DJIA SPX COMP were lower, however, as Middle East tensions weighed on risk-taking sentiment and as investors looked ahead to a busy week of corporate earnings, along with a fresh round of inflation data on Thursday.

"From our perspective, the 10-year yield is trying to figure out where the Fed ultimately settles out on rates," said Michael Reynolds, vice president of investment strategy at Glenmede, which oversees $45.5 billion in assets from Philadelphia. "There are a lot of cross currents - including a labor market that's holding up and bucking some of the pessimistic fears we saw earlier, and the economy remaining resilient - with implications for how far the Fed goes, and where neutral is for the Fed."

"A soft-landing is our base-case scenario and sticking the landing is what we are watching for," Reynolds said via phone. With traders paring back on the extent of rate cuts they expect this year, stock investors are "reassessing what the fair value on equities is right now."

-Vivien Lou Chen

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10-07-24 1207ET

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