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That was quite the turn in the markets last week. The whiplash from bullish to bearish action has everyone whispering the word “recession”. Before we panic, let’s assess what’s actually happening in the markets.

After rising sharply midweek following a rather dovish Fed statement, sellers began shedding stocks at a ferocious clip. Most indices were down 3-5% during August’s first two trading sessions. Meanwhile, options trading levels were off the charts (August may approach a record number!).

On Friday, the VIX hit 29%, and the put/call ratio was over one. The fear in the air was palpable.

As equity markets declined, bond markets rallied hard – no surprise there. The 10-year Treasury yield fell to just below 3.8% on the close Friday, the lowest level since last December. At that time, markets were about to finish up on a strong year of trading. However, given seasonal patterns, it begs the question: Are low yields predicting something more ominous?

The bond market may think a recession is coming

Maybe! Maybe the bond market is anticipating a difficult economic period ahead. When yields fall this quickly, it often means people are leaning too hard in one direction.

I believe some bond short sellers had to cover their positions quickly as economic data (rising unemployment) showed slower growth in the back half of the year. If the job market deteriorates and can no longer guide us towards a soft landing, we could see layoffs, even slower growth, and possibly a recession. Hence, bond buyers were reaching for yields by the end of the week.

But are they wrong?

Bond investors are paranoid. They have predicted six of the last two recessions.

But we can’t ignore the fear of an economic slowdown. The Fed Funds Futures market is speculating far more rate cuts in 2024 than the Fed has discussed publicly. Some big banks like Goldman Sachs and Citigroup are predicting rate cuts down to 4% (from the current 5.25%), which is extremely aggressive.

The last time the market disconnected from the Fed’s “gradual” message was in April when markets swiftly dropped 4-5%. The aggressive Fed Funds Futures retreated quickly to align with the Fed’s message. Will they this time? We’ll find out.

For now, let’s watch the data. If cooler heads can prevail, everyone will likely change their tune. And if a recession happens, we’ll be ready.

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