US government bonds rally after factory data height in recession fears

US government bonds rally after factory data height in recession fears

US government bonds rallied sharply on Friday after a gloomy report on America’s factory sector intensified concerns over the outlook for the world’s biggest economy.

The yield on the 10-year Treasury note, a benchmark for global government bond markets as well as consumer loans and mortgages, dropped 0.13 percentage points to 2.88 per cent in thin trading before a holiday weekend in the US. The yield has fallen nearly 0.3 percentage points over the past three days in the biggest such moves since 2020.

In equities, US stocks ended the day higher, with the benchmark S&P 500 index up 1.1 per cent following its worst performance for the first half of a year since 1970. The tech-heavy Nasdaq rose 0.9 per cent.

A closely watched survey from the Institute for Supply Management showed the pace of growth in the US manufacturing sector declined sharply in June from May. At the same time, executives polled by the organization indicated new orders submitted to factories and employment conditions deteriorated because of long lead times and high prices.

Weaker data, such as Friday’s, have investors worried that measures to tamp down intense inflation by central banks including the Federal Reserve, European Central Bank and Bank of England will derail big global economies.

“The ISM report, along with many other business surveys, points to recent weakening in the economy,” said Daniel Silver, economist at JPMorgan.

The soft economic data led JPMorgan to revise down its second-quarter growth estimates on Friday, from 2.5 per cent to 1 per cent.

The Atlanta Fed’s GDPNow model, with the ISM data and a report on construction from the Census Bureau from Friday incorporated, forecast the US economy would contract by 2.1 per cent in the second quarter. That would be a second consecutive quarter of contraction, a traditional definition of recession.

Line chart of 10-year Treasury yield (%) showing US government bond sell-off partially unwinds

The data also came after carmaker General Motors announced a 15 per cent drop in quarterly sales.

The Fed lifted its benchmark interest rate by an extra-large 0.75 percentage points last month to a range of 1.5 to 1.75 per cent. Markets expect the funds rate to reach 3.3 per cent by March, although these forecasts derived from trading in the futures market have been scaled back significantly from close to 4 per cent a few weeks ago.

The declining expectations for rate rises and worsening economic outlook have pushed US bond yields from recent highs. The two-year yield—which moves with interest rate expectations—has fallen about 0.6 percentage points from a mid-June high of nearly 3.5 per cent.

“It’s a continuation of the recession worries that we have seen this week. The market is questioning the Fed’s commitment to hike,” said Ben Jeffery, a strategist at BMO Capital Markets.

Fed chair Jay Powell conceded last week that a US economic downturn was “certainly a possibility” and avoiding it depended largely on factors outside the central bank’s control.

Line chart of Expected average federal funds rate in March 2023* showing Fed rate rise expectations pull back from recent highs

Investors may also be betting on a less aggressive Fed because they believe higher rates have already begun to bring inflation down.

The five-year, five-year break-even rate — a measure of where the market believes inflation will be in five years’ time for five years — on Friday fell to its lowest level since January 2022. Some of that move had reversed by the end of day.

“The outlook for inflation is going down rapidly. And I think that even though we may see one more set of sticky numbers on July 13 (the next CPI report), inflation is moving down,” said Andy Brenner, head of international fixed-income at NatAlliance Securities.

A rally in European bonds on Friday also accelerated after the ISM report. Germany’s 10-year Bund yield fell by 0.1 percentage points to 1.23 per cent, with yields on UK and French government bonds also declining.

“We’re seeing demand coming back for bonds as a haven asset,” said Aneeka Gupta, research director at ETF provider WisdomTree.

“There are concerns that central banks globally, in order to try and tame inflation, are now engineering not just a soft landing but pushing economies into recession,” she added. That, Gupta explained, could lead to a “policy mistake that forces them to reverse course” on interest rates.

European stocks ended the day roughly flat, with the Stoxx 600 closing down 0.02 per cent. Utilities, which are shielded from much inflationary pressure, was the best performing sector in the Stoxx 600, up 3.1 per cent on the day.

In currencies, the dollar index, which measures the US currency against six others and rises in times of economic stress, rose 0.4 per cent.

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