Will the Federal Reserve lower interest rates soon? The bond market certainly thinks so.
On Friday, the yield on two-year Treasury notes dipped below the Fed's 6% target rate on federal funds, or overnight interbank loans.
By contrast, the two-year Treasury yield typically exceeds the federal funds rate by roughly 100 basis points, economists said.
"The market looks like it expects credit to be eased any minute," said Gary L. Ciminero, chief economist at Fleet Financial Group, Providence, R.I. "The Fed must be struggling to hold federal funds at 6%."
"The bond market seems to be saying the funds rate ought to be closer to 5% than 6%,"said Sung Won Sohn, chief economist at Norwest Corp., Minneapolis.
Despite the inverted relationship, Mr. Ciminero said the Fed is unlikely to reverse its tightening posture at a time when the dollar is under pressure.
In fact, the dollar's travails may partly explain what is happening: As the central banks of Japan and other foreign nations buy dollars to support the value of U.S. currency, the proceeds are funneled back into the Treasury market via Fed purchases, pushing bond prices up and yields down.
Still, evidence of a weaker economy surfacing in recent reports provides compelling support for a Fed easing, Mr. Ciminero said.
A further sign of the market's comfort about price stability is seen in the 6.75% yield on the benchmark 30-year Treasury bond. That is only 75 basis points above the target overnight funds rate, Mr. Ciminero pointed out.
Mr. Sohn said he is "inclined to think the Fed may have to speed up the cutting of rates to this summer."
The Fed's monetary policymakers next meet on July 5. Mr. Sohn said he would not rule out a rate cut at that time, though he acknowledged that the probability is slim.
The Norwest economist expects evidence of sluggish business conditions to mount further this week when the monthly employment report for May is released. April's report was weak.
"Probably April and May should be looked at together. If the monthly average growth in payrolls over that period is below 100,000, we will have a very convincing sign of a slowdown," he said.
Mr. Sohn sees a 45% likelihood of a recession later this year or early next year. That is up from his 40% weighting a month ago.
Correspondingly, Mr. Sohn lowered the likelihood of a soft landing to 55% from 60%. In that scenario, the Fed would slow the economy to inflation-curbing levels without provoking an outright downturn.
Mr. Ciminero said: "I don't think a recession is right around the corner, but I may lower my expectations of a soft landing."
The Fleet economist says the annualized economic growth rate may slow to under 2% either this quarter or next - and perhaps to as low as 1.5% or even 1%.
"Zero growth or less" in gross domestic product is possible for a couple of future quarters, he added.
But Mr. Ciminero says there are several reasons why a full-scale recession still does not seem in the cards.
First, only a mild inventory correction seems imminent, he said. A full- blown decline usually involves a big reduction of inventory.
Second, the housing sector decline may be arrested by the fall in mortgage rates. Though a recession typically provokes a sharp fall in housing activity, he says, the current decline has been "only half deep."
Third, capital spending has been "roaring along" at double-digit annual rates, although it seems recently to have begun slowing down.
Finally, Mr. Ciminero noted that the export sector is gaining a lift in competitiveness from the weakness of the dollar. "It's difficult to have a recession when you have 12% of the economy growing at 9% a year," he said.