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Thursday March 30, 2023
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In the weeks since the collapse of Silicon Valley Bank and the associated crisis in global banking, the US Treasury market has been the nexus of dramatic price moves that have shaped investor sentiment.
And what really stood out about this volatility was the swing in the yield on 2-year Treasury notes.
As we noted earlier this month, Treasury and bond yields can be thought of as the average of the Federal Reserve’s benchmark interest rate over that period.
As a result, the 2-year rate is often considered to be the most representative of the short-term interest rate path, as it reflects what traders believe to be the average Fed Funds rate over the next two years.
From peaking at 5.05% on March 8, the 2-year yield has fallen more than 100 basis points, or more than 1 percentage point, over the past few weeks while trading as low as 3.76% on March 24.
With the 2-year yield settled closer to 4.1% on Wednesday and the Fed’s benchmark target range of 4.75% to 5%, we can rest assured that the market is pricing in a sharp rate cut by March 2025 .
But according to some economists, pricing in three or four rate cuts by the Fed over the next two years is dividing the gap on what a longer, broader banking crisis might or might not mean for markets.
“There is no middle ground [a] Banking crisis, it either happens or it doesn’t,” Neil Dutta, chief economist at Renaissance Macro, wrote in an email on Wednesday.
“That means the bond market is either pricing in too many rate cuts or not pricing in enough.”
As the dust clears from the initial spate of bank failures, forced takeovers and rumors of more failures, investors appear to be facing a renewed risk that has plagued bond markets for the better part of a year. The risk that the economy will remain stronger than expected while the Fed hikes rates for longer than expected.
The story goes on
In a note to clients released on Wednesday, Bank of America Global Research rates strategists, led by Bruno Braizinha, flagged recent stress in the banking sector, sparked by Silicon Valley Bank, and pulled expectations for a Fed pause by around 5 months ago.
Investors trimmed expectations for when the Federal Reserve will pause its rate hikes by 5 months within weeks of March. (Source: Bank of America Global Research)
“The economic impact of the recent banking stress is highly uncertain and interest rate markets are about six hikes away from the expected policy rate priced in at the December 2023 FOMC meeting,” the Bank of America team wrote.
Specifically, over the past 9 months, investors have been betting that an end to the Fed’s rate hike cycle could come in about 6 months.
In other words, the bond market was too bearish on the economy and optimistic Fed Chairman Jay Powell would stop pounding fixed income investors.
“We see downside risk to our forecasts if the credit cycle turns, but if data proves resilient and banks’ concerns abate, the market could moderate some of the recent rally and refocus on risks of renewed acceleration, that arose shortly before the crisis of confidence began in the banking sector,” wrote the BofA team.
Or as Dutta said: “[The] The main risk is that the conditions are okay.”
Federal Reserve Board Chairman Jerome Powell holds a news conference after the Fed hiked interest rates by a quarter of a percentage point after a two-day Federal Open Market Committee (FOMC) meeting on interest rate policy in Washington, United States, March 22. 2023. Portal/Leah Millis
“In the medium term, the Fed thinks so [a] Sudden halt to the economy,” Dutta wrote. “Assuming current tracking estimates are ballpark-bound, hitting the Fed’s GDP estimate implies real growth contracts [at a seasonally adjusted annualized rate of 0.5%] in each of the next three quarters.”
Last week, the Fed’s latest economic forecasts suggested GDP will grow just 0.4% this year, down from the 0.5% expected in December. Next year isn’t going to be much better, with expected GDP growth of just 1.2%.
However, data from the Atlanta Fed suggests the economy grew at an annual rate of 3.2% in the first quarter of the year. As such, Dutta argues that it takes consecutive quarters of negative growth for the Fed’s projections of such a strong first quarter to come to fruition.
Forecasts that also called for interest rates to end the year slightly higher than today. That means it doesn’t take much more than stabilizing the US economy to make 2023 look like 2022 for those who are betting on the Fed quitting.
“So the main risk is that the conditions are okay,” Dutta wrote.
“No reacceleration, no gangster, but okay. That’s a low bar in my opinion.”
What to see today
Business
Personal Income, February (+0.3% expected, previously +0.6%); Personal spend, February (+0.3% expected, previously +1.8%); MNI Chicago PMI, March (43.9 exp., 43.6 previous); University of Michigan Consumer Sentiment, March (63.4 expected, 63.4 before)
merits
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