Yield Warning VS Risk Asset Carnival! Diverging Expectations of Recession for US Treasuries and US Stocks

The Zhitong Finance APP learned that the disappointing U.S. non-farm payroll data released last week prompted fixed-income investors to quickly factor in expectations of a sharp economic slowdown. However, in the stock and credit markets, there is hardly any trace of the employment report's impact. This week, various high-risk trades surged again, restoring a dazzling upward momentum, despite a series of signals raising doubts about the sustainability of economic growth. The Nasdaq 100 index recorded its largest weekly gain in over a month, Bitcoin halted its short-term decline, and high-yield bond spreads narrowed for five consecutive days.

This once again reflects that risk appetite has overwhelmed market skepticism against the backdrop of soaring corporate profits and a resurgence of the artificial intelligence boom. According to JP Morgan data, the recession probability reflected in the stock and corporate credit markets is only in single digits, far lower than the implied probability in the U.S. Treasury market. In the Treasury market, traders recently bet that there could be up to three rate cuts in the coming months.

Mark Freeman, Chief Investment Officer of Socorro Asset Management, stated, "It's really hard to convince yourself to connect these phenomena. At most, we can say that high-yield bonds and stocks convey the same message—no recession, and valuations are extremely high, so the risks are inherently large. We can certainly discuss whether this situation is reasonable or what is driving it, but this is the reality at the moment."

Last Friday's U.S. July employment report shook the market, causing the two-year U.S. Treasury yield to record its largest single-day drop since 2023, and the S&P 500 index fell 1.6% that day. Subsequently, market reactions diverged, reflecting investors' disagreements over the economic signals conveyed by the data. This week, U.S. Treasury yields have rebounded, but the 10-year U.S. Treasury yield remains about 10 basis points lower than before the report was released—part of an overall downward trend over the past month—after data showed that the average non-farm payroll growth in the U.S. over three months fell to its lowest level since 2020. Meanwhile, the U.S. stock market easily recovered its previous losses, with the Nasdaq 100 index rebounding 1.7% from the previous day's closing price, and the S&P 500 index rising on three out of five trading days this week.

This week's economic data further raised concerns—U.S. services weakened and price pressures remained stubborn, initial jobless claims rose to the highest level since November 2021, and consumer inflation expectations increased. Affected by these weak signals, long-term bond yields have continued to decline over the past month.

Matt Maley, Chief Market Strategist at Miller Tabak + Co., stated: "Many people don't realize that in the context of an expensive stock market, the decline in long-term yields is actually bearish for stocks. When the stock market and bond market diverge, the bond market is almost always the one that judges correctly in economic terms."

Historical data shows that an economic recession occurs on average every five years. Therefore, Que Nguyen, Chief Investment Officer of Equity Strategies at Research Affiliates, believes that as the current economic expansion enters its mature phase, the odds for optimists are decreasing.

Que Nguyen pointed out that in the ever-changing policy environment under Trump, it has become increasingly difficult to extract clear economic signals from the market, as these policies seem to inject volatility into every major asset class. Taking commodities as an example, investors often view them as a source of growth signals. Last month, Trump's exemption of tariffs on certain copper products led to a decline in copper prices; while this Friday, a ruling that included gold bars in the tariff scope caused turmoil in the gold market.

Que Nguyen stated, "In the later stages of the economic cycle, the real surprise is not that recession indicators are rising, but that they are not rising." "This is why more emphasis should be placed on the signals from the Treasury market rather than the seemingly overly optimistic signals from the high-yield bond market."

Economists believe that the probability of the U.S. economy falling into recession is only 35%, down from 65% in 2023. The second-quarter earnings season has also boosted market sentiment. Data shows that the S&P 500 index's second-quarter earnings are expected to grow by 10% year-on-year, four times the pre-earnings season expectations.

Winnie Cisar, Global Head of Strategy at CreditSights, stated, "Overall, risk assets are supported by strong technicals, the market believes the Federal Reserve will not fall behind the curve and has ample room to ease policy when necessary, and better-than-expected corporate earnings." "Although there are still questions about the fundamentals, especially in the credit market, investors are still driven by strong capital inflows, which have maintained the resilience of spreads."

It is worth mentioning that past instances of divergence have also ended with the stock market winning, such as in 2023 and 2024, where despite multiple concerns about recession in the Treasury market, a recession did not occur. JPMorgan strategist Nikolaos Panigirtzoglou stated, "The interest rate market, being more sensitive to growth risks, has priced in a much higher probability of a U.S. recession than the credit market. This divergence has occurred several times in recent years, and the credit market has proven to be the correct side."