Wall Street stocks declined and the yield on short-term US government debt soared after Federal Reserve chair Jay Powell warned that the central bank could more aggressively raise interest rates if the economy grows too quickly.

Powell’s comments sent the yield on the policy-sensitive two-year US Treasury above 5 per cent for the first time since 2007, pushing a closely watched recession indicator to its lowest level since 1981 and prompting a rally in the US dollar.

Wall Street’s benchmark S&P 500 fell 1.5 per cent, weighed down by financials. The tech-heavy Nasdaq Composite dropped about 1.2 per cent. Losses in New York accelerated in the afternoon after Powell warned in congressional testimony that if economic data indicated “that faster tightening is warranted, we would be prepared to increase the pace of rate hikes”.

The Fed lifted borrowing costs by a quarter percentage point at the start of February, seeking to slow the pace of rate rises after a series of aggressive increases last year were meant to curb surging inflation.

A flurry of strong economic data since the start of February suggested that inflation may prove stickier than previously expected, while the labour market has continued to be robust.

Powell’s comments constitute “a rare admission that the Fed made a mistake” by slowing the pace at which it raised rates over the winter, said Steven Blitz, chief US economist at TS Lombard. He said the Fed would probably revert to raising rates by 0.5 percentage points when it next meets if February’s jobs numbers, out on Friday, confirm that the US economy remains in relatively strong health.

Short-term US government bond prices sank on the day, with the yield on the two-year Treasury, which is sensitive to monetary policy expectations, rising above 5 per cent for the first time since 2007. In contrast, the yield on the benchmark 10-year Treasury fell to 3.97 per cent.

Following Powell’s remarks, the spread between two-year and 10-year Treasuries surpassed negative 1 percentage point for the first time since September 1981. A negative reading, or “inverted” yield curve, is regarded as a signal of an impending recession.

The diverging moves in Treasuries signal that markets expect the Fed “is going to have to cause a recession to bring inflation under control”, said Lyn Graham-Taylor, senior rates strategist at Rabobank.

Traders on Tuesday forecast a 62 per cent chance of a half-point raise at the Fed’s next meeting on March 21 and March 22, according to Refinitiv. Futures markets now expect US rates to peak at about 5.63 per cent in September, up from 5.47 per cent in the same month before Powell’s remarks.

At the end of February, JPMorgan analysts attached a 70 per cent chance to the possibility of a recession “in late 2023 or 2024”.

The dollar strengthened on the prospect of more monetary policy tightening, gaining 1.2 per cent against a basket of six international peers.

European stocks mostly declined on Tuesday, with the region-wide Stoxx 600 down 0.8 per cent. London’s FTSE 100 declined 0.1 per cent.

Chinese equities also slipped after disappointing trade data added to investors’ concerns that the country’s post-zero Covid recovery might prove less explosive than previously expected.

China’s CSI 300 fell 1.5 per cent and Hong Kong’s Hang Seng index lost 0.3 per cent after imports in January and February declined 10.2 per cent compared with the same period a year earlier. Exports fared better, falling just 6.8 per cent. Analysts had expected declines of 5.5 per cent and 9.4 per cent for imports and exports, respectively.

“Either reopening has yet to provide much support to import demand, perhaps because many consumer-facing services are not import intensive, or any boost has been offset by a further drop in imports for processing and re-export,” said Julian Evans-Pritchard, senior China economist at Capital Economics.

Tuesday’s Chinese trade figures came after outgoing premier Li Keqiang earlier this week told the annual National People’s Congress that the aim for economic expansion for 2023 was “around 5 per cent” — the country’s lowest growth target for more than three decades.

In commodities, international oil benchmark Brent crude settled 3.4 per cent lower at $83.39 a barrel, while US equivalent West Texas Intermediate fell 3.6 per cent at $77.58 a barrel.