(Bloomberg) -- US short-term yields slumped Friday as slower-than-anticipated wage growth and an unexpectedly weak services-sector indicator prompted traders to trim expectations for just how high the Federal Reserve might push its overnight benchmark.

The moves reversed the previous day’s bond-market selloff and came even as job growth and the unemployment rate for December were better than expected. 

Most segments of the Treasury yield curve steepened as two- and three-year yields each plummeted around 20 basis points and were near their session lows late in New York. Still, three-month bill yields exceeded the 10-year by a full percentage point for the first time in decades as another Fed rate increase is expected in February. That gap is seen by many as a reliable signal that a recession could be in store.

Swap contracts referencing Fed meeting dates showed investors now expect the policy rate to peak at under 5% this cycle, down from 5.06% just before the latest employment data. While traders remain split about the size of the February move, the 33 basis points priced in suggests 25 basis points is now considered more likely than 50. Longer-dated contracts still anticipate rate cuts by year-end.

The dollar fell and was down 1.1% late on Friday, while the S&P 500 index closed 2.3% higher. 

“Bad news is now good news, as the softer non-manufacturing ISM report, combined with the soft wage data within payrolls, has given a bid to risk,” said John Brady, managing director at RJ O’Brien.

The US jobs data capped a week of solid labor market metrics that sparked a run up in Treasury yields. A survey of private hiring and the JOLTS job openings suggested underlying demand for workers that in the current environment of hot service sector inflation could keep the Fed on course for further rate hikes. 

On the other hand, the Institute for Supply Management’s services gauge unexpectedly shrank at the end of 2022, with steep declines in measures of business activity and orders that, if sustained, risk heightening concerns about the demand outlook. The release of that data after the jobs report turbocharged earlier front-end moves and pushed the curve inversion back into deeper territory.

The debate over a quarter or half-point hike at the next Fed meeting “now comes down to next week’s CPI print,” Ian Lyngen, head of US rate strategy at BMO Capital Markets, said in a note after the jobs data. Consumer Price Index changes for December to be released Jan. 12 are expected to show further slowing from last year’s generational highs.

Atlanta Fed President Raphael Bostic said Friday that despite cooler-than-expected wage data that the Fed has more work to do, and that he’s open to a second straight half-point increase.

Read more: Fed’s Bostic Open on Size of Interest-Rate Hike at Next Meeting

The policy sensitive two-year Treasury yield fell 21 basis points to 4.25% while the 10-year benchmark was down 16 basis points at about 3.55% late Friday.

Nonfarm payrolls increased 223,000 in December, capping a near-record year for job growth, a Labor Department report showed Friday. The advance followed a revised 256,000 gain in November. Average hourly earnings rose 0.3% from a month earlier and 4.6% from December 2021 after a downward revision to November.

While bond traders often fixate on the two- to 10-year and five- to 30-year yield spreads, the three-month to 10-year gap is a touchstone for economists because it inverted before each of the past eight US recessions, with a typical lag of 12 to 18 months. The predictive power of the spread was identified during the 1980s by Campbell Harvey, now a professor at Duke University’s Fuqua School of Business.

--With assistance from Maria Elena Vizcaino and Edward Bolingbroke.

(Updates pricing.)

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