In the weeks since Silicon Valley Bank's collapse and associated crisis in the global banking world, the U.S. Treasury market has been ground zero for dramatic price moves shaping investor sentiment.
And the standout within this volatility has been the swing in the yield on 2-year Treasury notes.
As we noted earlier this month, the yield on Treasury notes and bonds can be thought of as the average of the Federal Reserve's benchmark interest rate over that period.
As a result, the 2-year is often seen as most representative of the near-term path of interest rates, capturing what traders think the fed funds rate will be, on average, over the next two years.
Since peaking at 5.05% on March 8, the 2-year yield has dropped more than 100 basis points, or more than 1 percentage point, in the last few weeks while trading as low as 3.76% on March 24.
With the 2-year yield settling closer to 4.1% on Wednesday and the Fed's benchmark target range standing at 4.75%-5%, we can comfortably say the market is pricing in a hefty cut in interest rates by March 2025.
But in the view of some economists, pricing in three or four rate cuts from the Fed over the next two years splits the difference on what a longer, fuller banking crisis would or would not mean for markets.
"There is no middle ground in [a] banking crisis, it either happens or it doesn't," wrote Neil Dutta, chief economist at Renaissance Macro, in an email on Wednesday.
"This means the bond market is either pricing in too many rate cuts or not enough."
So as the dust clears on the initial burst of bank failures, forced takeovers, and rumored next-to-falls, it seems investors are again facing a risk that has plagued the fixed income markets for the better part of a year. The risk the economy stays stronger than expected while the Fed raises rates for longer than expected.
In a note to clients published Wednesday, rates strategists at Bank of America Global Research led by Bruno Braizinha flagged the recent banking sector stress triggered by Silicon Valley Bank and pulled forward expectations for the Fed to pause by about 5 months.
"The economic impact of recent banking stress is highly uncertain and rate markets removed about six hikes from the expected fed funds rate priced into the December 2023 FOMC meeting," Bank of America's team wrote.
Notably, investors have been betting that an end to the Fed's rate hiking cycle could come in about 6 months for the last 9 months.
In other words, the bond market has been too pessimistic about the economy and optimistic Fed Chair Jay Powell would stop hammering fixed income investors.
"We see downside risk to our forecasts if the credit cycle turns, but if data proves resilient and banking concerns subside, the market may unwind some of the recent rally and focus back on the re-acceleration risks that were arising just before the confidence crunch started in the banking sector," BofA's team wrote.
Or as Dutta said: "[The] main risk is that conditions are fine."
"Medium-run, the Fed assumes [a] sudden stop in the economy," Dutta wrote. "Assuming current tracking estimates are in the ballpark, to hit 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 officials see GDP growing just 0.4% this year, down from the 0.5% expected in December. Next year doesn't get much better, with GDP growth expected to clock in at just 1.2%.
Data from the Atlanta Fed, however, suggests the economy has grown at an annualized rate of 3.2% in the first quarter of the year. Hence the consecutive quarters of negative growth Dutta cites as being needed for the Fed's forecasts to come to fruition with Q1 that strong.
Forecasts that also called for rates to end the year slightly higher than where they stand today. Meaning it won't take much more than holding steady from the U.S. economy for 2023 to look like 2022 for those betting on the Fed to call it quits.
"Thus, the main risk is that conditions are fine," Dutta wrote.
"Not reaccelerating, not gangbusters, but just okay. That's a low bar to clear, in my view."
What to watch today
Economy
- Personal income, February (+0.3% expected, +0.6% previously); Personal spending, February (+0.3% expected, +1.8% previously); MNI Chicago PMI, March (43.9 expected, 43.6 previously); University of Michigan consumer sentiment, March (63.4 expected, 63.4 previously)
Earnings
- No notable companies set to report.
