(MarketWatch)–A closely watched measure of the Treasury yield curve is less inverted than it was earlier in March, though the reasons for the move are nuanced.

Fears about the global banking system, exacerbated on Friday as shares of German financial giant Deutsche Bank (DBK.XE) tumbled, has bond traders revisiting the idea of a full percentage point of rate cuts from the Federal Reserve by year-end — a notion that initially surfaced last week as concerns about Swiss giant Credit Suisse (CSGN.EB) intensified. This time around, traders, investors and analysts are worried about a broader pullback in overall lending by banks. Read:Moody’s sees risk that U.S. banking ‘turmoil’ can’t be contained

Also see: Deutsche Bank’s debt insurance spikes, but eurozone bank levels aren’t that different from last yearConcerns about an abrupt pullback in bank lending are among the reasons for Friday’s drop in the 2-year yield , which finished the New York session with its biggest three-week decline since the period that ended Nov. 6, 1987. The 2-year rate’s decline outpaced that of the 10-year yield , resulting in a less-negative spread between the two of minus 39.8 basis points relative to March 8’s level of minus 109 basis points. A negative 2s/10s spread simply means that the policy-sensitive 2-year rate is still trading above the benchmark 10-year yield.

However, Friday’s moves produced what’s known as a bull steepener (bull refers to the demand for bonds that’s pushing down yields, steepener refers to the direction of the spread). It’s a fairly rare occurrence that doesn’t happen unless there’s an “extreme
event” or the market expects the Fed to begin easing, according to Greg Faranello of AmeriVet Securities. The yield curve is “telling me the s– is hitting the fan,” Faranello, who runs trading for the veteran-owned broker dealer in New York, said via phone.

Indeed, just because the 2s/10s spread is out of triple-digit negative territory doesn’t mean the outlook has gotten better for the U.S. economy. The spread, one of the bond market’s most reliable gauges of impending recessions, is still below zero — meaning a slowdown in growth is still seen on the horizon. However, the speed with which the 2-year yield has been dropping is sending its own signal: that policy makers should be close to cutting interest rates because the economy is rapidly slowing, said Tom Graff, head of
investments at Baltimore-based Facet, which manages more than $1 billion in assets. “The power of an inverted curve as a recession indicator is pretty forward-looking, and the fact that it is un-inverting doesn’t tell us much about whether we are closer to a recession or not,” Graff said via phone Friday. “But when short-term rates fall faster than long-term ones, that usually means the economy is slowing in real time,” he said. “The bond market is screaming rate cuts because it thinks the banking crisis will result in bringing down inflation, and it is extremely concerned about what’s going on in banks. “For investors, all of the recent financial-market moves may feel a bit like whiplash. It was only on March 7, or roughly two weeks ago, that hawkish congressional testimony by Fed Chairman Jerome Powell pushed the policy-sensitive 2-year rate above 5% for the first time since June 2007.

At the time, the focus was on stronger-than-expected economic data that had rolled in. Traders and investors have been trying to adjust to the fastest and most aggressive rate-hike cycle in about 40 years, as well as all of its ramifications. This week’s volatility in the 2-year Treasury “is unprecedented” and likely related to “the extreme, levered short positioning by hedge funds,” said Ben Emons, a senior portfolio manager and head of fixed income at New Edge Wealth in New York. Financial-market players have gone from thinking that the Fed doesn’t care what happens to the economy as it keeps hiking, “to, in a weird way, seeing a slowdown in the economy and inflation, credit contraction, Fed easing, and a central bank that’s going to be successful at some point — all at the same time,” Faranello said. “I don’t necessarily agree with it, but that’s how we’re trading right now. “For now, fed funds futures traders are factoring in a 92.4% chance that policy makers will pause in May, leaving the main interest-rate target between 4.75% and 5%, according to the CME Fed Watch Tool. Meanwhile, traders also see a 38% chance that the fed-funds rate will drop a full percentage point, to 3.75%-4%, by December, with a decent chance that the first rate cut will take place in June. Some fallout at U.S. banks was only to be expected.

Powell himself indicated earlier this week that stricter lending standards by banks could slow the economy and inflation in a manner somewhat similar to a rate hike. What rattled markets on Friday about reports on the spiking cost to insure Deutsche Bank’s debt against any default is the suggestion that the banking turmoil isn’t contained in Europe, according to Graff. “All of this is happening very rapidly in real time,” Facet’s head of investments said. “Officials have tools to prevent widespread bank failures, and can deal with that. The problem is that every bank is going to bend over backward to show how conservative it is, and that’s what’s happening now. No matter which way you look at it, banks are getting more conservative and that makes a big difference on how much the economy can grow.”

-By: Vivien Lou Chen