The Fed’s interest rate plans remain a focal point for the market. It’s hard to believe, but the Fed’s first rate hike was only a year ago (on 3/16/22). Since then, the Fed has pursued its fastest ever series of rate hikes, reflected in the surge in the 1yr Treasury from 0% to 5.07%, including four 75 bps rate hikes over the course of 2022, to slow the surge in inflation (shown by Core CPI). Inflation has eased from its recent peak and, thanks to the rate hikes, the markets believe inflation will continue to fall, as reflected in the TIPS implied inflation rate of just 2.42%. The question is how much the economy will be impacted by this rapid shift.
Chart 1
The Fed’s main economic objective is to slow inflation, although this can have side effects of slowing economic activity. CPI is falling and there are reasons to think it will keep falling. The oil price spike from Russia invading Ukraine has faded since June 2022. Prices of goods ranging from cars to food to technology and other goods, are all declining as Covid related supply chain issues have been straightened out. The final area of inflation is shelter. But the CPI’s calculations are notoriously slow, and multiple faster data series suggest this final component should start to decline soon.
Chart 2
In fact, as of the end of February, the market debate was whether the economy would experience a soft landing, or no landing at all. As Q1 progressed, it seemed the Fed’s “Raise and Hold” narrative was finally taking hold. The best evidence of this was the 2yr Treasury, shown in the chart to the left. The 4-4.5% plateau from September through January represented the market questioning the Fed raising rates over 5% and staying there, known as “raise and hold”. However, the month of February saw the 2yr make a steady march from 4% to 5%, as economic data and steady Fed messaging won over skeptical markets. While the 10yr rose 50 bps, the 2yr was up 100 bps. Not only did the rise in rates weigh on bond prices, but it caused the stock market to pull back as well. Two months into the quarter, it seemed the Fed had finally convinced the market to price higher rates.
This quickly shifted in the first week of March, when the sudden collapse of Silicon Valley Bank and Signature Bank unleashed volatility in the short-term fixed income markets. There were several reasons for this. First, with the economy at risk, expectations for more Fed rate hikes quickly faded. Second, from a supply / demand standpoint, the overnight runs on two banks caused depositors at other banks to make withdrawals, and some of those flows ended up in short term bonds, where higher demand pushed prices up and yields down.
In just 3 days, the prior month’s steady rise in yields was completely unwound, and the 2yr went back below 4%. That move, plus subsequent volatility as bank concerns lingered, followed by a Fed meeting on 3/22, has created volatility in the bond market that many experienced traders say they have never seen.
Chart 3
While hyperbole is common, looking at Chart 3, the movement in the 2yr yield (which is one of the safest securities in the world) really has never been seen before
Chart 3 shows the trailing one month average of daily absolute value yield changes; in other words, how much has the yield moved up or down each day of the preceding month. The current reading, 0.16%, is the highest in the data back to 1986. The prior two spikes were the 1987 stock market crash (when the Dow Jones fell 20% in one day) and the height of the GFC in October 2008. On top of that, this period of volatility exceeds any period the much more volatile 10yr Treasury has experienced.
These two prior periods of high bond market volatility also saw high stock market volatility. Yet today, once again, an unprecedented market relationship has unfolded, as the stock market overall has been much calmer, as even though the financial sector has been volatile, other sectors have been more stable.
The Markets Changed Course as Economic Winds Shifted, going quickly went from finally pricing raise and hold amidst a “no landing” versus “soft landing” debate, back to pricing rate cuts and an economic slowdown.
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