Yields on 3-month BX:TMUBMUSD03M
and 6-month BX:TMUBMUSD06M
Treasury bills have been seeing yields north of 5% since March when Silicon Valley Bank’s collapse ignited fears of a broader instability in the U.S. banking sector from rapid-fire Fed rate hikes.
Six months later, the Fed, in its final meeting of the year, opted to keep its policy rate unchanged at 5.25% to 5.5%, a 22-year high, but Powell also finally signaled that enough was likely enough, and that a policy pivot to interest rate cuts was likely next year.
Importantly, the central bank chair also said he doesn’t want to make the mistake of keeping borrowing costs too high for too long. Powell’s comments helped lift the Dow Jones Industrial Average DJIA
above 37,000 for the first time ever on Wednesday, while the blue-chip index on Friday scored a third record close in a row.
“People were really shocked by Powell’s comments,” said Robert Tipp, chief investment strategist, at PGIM Fixed Income. Rather than dampen rate-cut exuberance building in markets, Powell instead opened the door to rate cuts by midyear, he said.
“Eventually, you end up with a lower fed-funds rate,” Tipp said in an interview. The risk is that cuts come suddenly, and can erase 5% yields on T-bills, money-market funds and other “cash-like” investments in the blink of an eye.
Swift pace of Fed cuts
When the Fed cut rates in the past 30 years it has been swift about it, often bringing them down quickly.
Fed rate-cutting cycles since the ’90s trace the sharp pullback also seen in 3-month T-bill rates, as shown below. They fell to about 1% from 6.5% after the early 2000 dot-com stock bust. They also dropped to almost zero from 5% in the teeth of the global financial crisis in 2008, and raced back down to a bottom during the COVID crisis in 2020.
Rates on 3-month Treasury bills dropped suddenly in past Fed rate-cutting cycles
FRED data
“I don’t think we are moving, in any way, back to a zero interest-rate world,” said Tim Horan, chief investment officer fixed income at Chilton Trust. “We are going to still be in a world where real interest rates matter.”
Burt Horan also said the market has reacted to Powell’s pivot signal by “partying on,” pointing to stocks that were back to record territory and benchmark 10-year Treasury yield’s BX:TMUBMUSD10Y
that has dropped from a 5% peak in October to 3.927% Friday, the lowest yield in about five months.
“The question now, in my mind,” Horan said, is how does the Fed orchestrate a pivot to rate cuts if financial conditions continue to loosen meanwhile.
“When they begin, the are going to continue with rate cuts,” said Horan, a former Fed staffer. With that, he expects the Fed to remain very cautious before pulling the trigger on the first cut of the cycle.
“What we are witnessing,” he said, “is a repositioning for that.”
Pivoting on the pivot
The most recent data for money-market funds shows a shift, even if temporary, out of “cash-like” assets.
The rush into money-market funds, which continued to attract record levels of assets this year after the failure of Silicon Valley Bank, fell in the past week by about $11.6 billion to roughly $5.9 trillion through Dec. 13, according to the Investment Company Institute.
Investors also pulled about $2.6 billion out of short and intermediate government and Treasury fixed income exchange-traded funds in the past week, according to the latest LSEG Lipper data.
Tipp at PGIM Fixed Income said he expects to see another “ping pong” year in long-term yields, akin to the volatility of 2023, with the 10-year yield likely to hinge on economic data, and what it means for the Fed as it works on the last leg of getting inflation down to its 2% annual target.
“The big driver in bonds is going to be the yield,” Tipp said. “If you are extending duration in bonds, you have a lot more assurance of earning an income stream over people who stay in cash.”
Molly McGown, U.S. rates strategist at TD Securities, said that economic data will continue to be a driving force in signaling if the Fed’s first rate cut of this cycle happens sooner or later.
With that backdrop, she expects next Friday’s reading of the personal-consumption expenditures price index, or PCE, for November to be a focus for markets, especially with Wall Street likely to be more sparsely staffed in the final week before the Christmas holiday.
The PCE is the Fed’s preferred inflation gauge, and it eased to a 3% annual rate in October from 3.4% a month before, but still sits above the Fed’s 2% annual target.
“Our view is that the Fed will hold rates at these levels in first half of 2024, before starting cutting rates in second half and 2025,” said Sid Vaidya, U.S. Wealth Chief Investment Strategist at TD Wealth.
U.S. housing data due on Monday, Tuesday and Wednesday of next week also will be a focus for investors, particularly with 30-year fixed mortgage rate falling below 7% for the first time since August.
The major U.S. stock indexes logged a seventh straight week of gains. The Dow advanced 2.9% for the week, while the S&P 500 SPX
gained 2.5%, ending 1.6% away from its Jan. 3, 2022 record close, according to Dow Jones Market Data.
The Nasdaq Composite Index COMP
advanced 2.9% for the week and the small-cap Russell 2000 index RUT
outperformed, gaining 5.6% for the week.
Higher interest rates may be painful in the short term, but banks, savers and the financial ecosystem will be better off in the long run, said Sheila Bair, former chair of the Federal Deposit Insurance Corp.
“When money is free, you squander it,” Bair said in an interview with MarketWatch. “It’s like anything. If it doesn’t cost you anything, you’re going to value it less. And we’ve had free money for quite some time now.”
Bair, who led the FDIC from 2006 to 2011, caused a stir recently in criticizing “moonshots,” the crypto industry and “useless innovations” like Bored Ape NFTs, which proliferated because of speculation and near-zero interest rates.
Her main message has been that the path to higher rates, while potentially “tricky,” ultimately will lead to a more stable financial system, where “truly promising innovations will attract capital” and where savers can actually save.
Former FDIC Chair Sheila Bair was dubbed “the little guy’s protector in chief” by Time Magazine in the wake of the subprime mortgage crisis.
Bair sat down for an interview with Barron’s Live, MarketWatch edition, to talk about the ripple effects of higher rates, what could trigger another financial crisis and why more regional banks sitting on unrealized losses could fail in the wake of Silicon Valley Bank’s collapse in March.
“We probably will have more bank failures,” Bair said. “But you know what? Banks fail. It’s OK. The system goes on. It’s important for people to understand that households stay below the insured deposit caps.”
“I know borrowing costs are going up, but your rewards for saving it are going up too,” she said. “I think that’s a very good thing.”
However, Bair isn’t focused only on money traps and pitfalls for grown-ups. She also has two new picture books coming out that aim to explain big financial themes to young readers, including where easy-money ways, speculation and inflation come from.
“One thing that I’ve learned from the kids is to not ask them what a loan is, because when I did that, a little hand when up, and she said: ‘That’s when you’re by yourself,’” Bair said.
While negative returns might stir bad memories of last year’s shocking losses for bonds, stocks and nearly everything else, investors holding Treasury debt issued at 2023’s higher yields might want to sit back and take stock.
“This is the top thing we hear,” said Ryan Murphy, director of fixed-income business development at Capital Group, of evaporating returns in what’s been a tough August. “You saw the worst bond market in 40 years last year. Investors, they are tired, and feel beaten up.”
Murphy’s message to clients is this: “In bonds, you earn the money over time.” And those dwindling bond returns since January? “Approach it with a deep breath, and know this is going to work out in the end.”
Capital Group’s laid-back style and lack of “a star CEO” earned it recognition by Institutional Investor in March as “a new bond leader” without a king, in large part because it attracted $100 billion in funds over the past five years, or twice the total of its peers.
Recent volatility in interest rates again zapped yearly gains in many bond funds, as Fed officials continued to warn that a roaring labor market and robust spending could keep inflation from receding to the central bank’s 2% annual target.
The spike in long-term bond yields makes older, lower-yielding securities look comparatively less attractive. That’s reflected in the yearly return on a key Bloomberg U.S. government bond and note index, which turned negative for the first time since March (see chart), when several regional banks failed, stoking fears of a broader banking crisis.
Returns on U.S. government bonds turn negative for the year.
FactSet
However, a look back at August 2022 shows the 10-year Treasury yield starting around 2.6%, according to FactSet.
By contrast, Treasury bill yields BX:TMUBMUSD06M
neared 5.5% on Thursday, or “north of anything we’ve seen over the past 15 years,” Murphy said. And for investors looking to lock in longer-term yields, the 10-year Treasury rate BX:TMUBMUSD10Y
touched 4.307% on Thursday, its highest level since November 2007, according to Dow Jones Market Data.
“It’s becoming more expensive for the government and companies to finance debt because of the rapid climb in rates,” Murphy said of the drag of higher long-term interest rates.
On the flip side, it’s also been one of the best stretches for lenders and bond investors in terms of getting paid to act as creditors since the 2007-2008 global financial crisis, but without a U.S. recession — or at least not yet.
What’s also different from last year is that the Fed already jacked up interest rates to a 22-year high of 5.25%-5.5% in July, and has signaled it’s likely nearly finished with hikes in this cycle.
Record cash on the sidelines
Murphy pointed to a mountain of cash on the sidelines, in the form of assets in money-market funds, as another potential stabilizer for markets.
Assets in money-market funds hit a record $5.57 trillion for the week ending Wednesday, according to data from the Investment Company Institute.
“What’s really interesting is that there’s been two bursts of investors going into money-market funds. There was a big shift right at the onset of COVID, and another burst over the past 12-18 months since the beginning of the rate-hiking cycle,” Murphy said.
Looking back to 2008, he pointed to a similar buildup in money-market assets, and a roughly $1.1 trillion wall of cash subsequently leaving the sector, as financial assets began to recover in the wake of the financial crisis.
“What we did see, while not all of it, was a healthy amount went back into fixed-income in the following years,” Murphy said.
Stocks closed lower Thursday and were headed for another week of losses, with the Dow Jones Industrial Average DJIA
2.3% lower on the week so far, the S&P 500 index SPX
down 2.1% and the Nasdaq Composite Index off 2.4%, according to FactSet.
U.S. stocks ended lower in volatile trade on Tuesday as investor jitters grew over limited progress in U.S. debt-ceiling negotiations as default deadline approaches. The Dow Jones Industrial Average DJIA, -0.69%
dropped 231 points, or 0.7%, to finish at 33,055. The S&P 500 SPX, -1.12%
was off 1.1%, posting its biggest daily decline since May 2, according to FactSet data. The Nasdaq Composite COMP, -1.26%
tumbled 1.3%. Representatives of President Joe Biden and congressional Republicans continued the debt-ceiling talks on Tuesday with no signs of progress as the deadline to raise the U.S. government’s $31.4 trillion borrowing limit is approaching. White House press secretary Karine Jean-Pierre on Tuesday said the 14th Amendment is not going to resolve Washington’s debt-ceiling standoff. Meanwhile, House Speaker Kevin McCarthy reportedly told Republicans that the negotiations still have some distance to go. Uncertainty around the standoff pushed yields on Treasury bills maturing between early and mid-June toward 6% on Tuesday. The yield on the six-month Treasury bill TMUBMUSD06M, 5.355%
also went up to as high as 5.41%, its highest level since 2000.
It was a two-week trading period like few had ever seen in the $24 trillion Treasury market.
In a span of roughly nine trading sessions between March 7 and 17, the yield on 2-year Treasury notes — a gauge of where U.S. central bankers are most likely to take interest rates over the next two years — sank a full percentage point to 3.85% from an almost 16-year closing high above 5%, with wide swings in both directions on the way down.
The 2-year yield’s yearlong upward trajectory made a sudden and dramatic descent, as investors swung from a view that interest rates would remain higher for longer to a scenario in which the Federal Reserve might need to cut borrowing costs to avert a deep recession and repeated bank failures. The wild swing in sentiment turned the 2-year Treasury rate TMUBMUSD02Y, 4.178%
into a roller-coaster ride and made it the most exciting space to watch in the traditionally staid government-debt market.
For traders like David Petrosinelli of InspereX in New York, a 25-year veteran of markets, March’s daily volatility was akin to “getting on an elevator with no buttons,” he said. He recalls telling people at his firm, who were worried about the positions they held at the time, that “a lot of this is a knee-jerk reaction to the unknown” — even if it felt both “eerily reminiscent” of rates volatility seen ahead of the 2007-2008 financial crisis, and “distinctly different’’ because it was driven by rapidly changing market expectations for the Fed and contained within the U.S. regional-banking system.
For more than a decade, there wasn’t much to say about the 2-year Treasury yield because the U.S. was mired in mostly low interest rates and “no one knew how to trade it,” according to Petrosinelli, 54, who began his career in the late 1990s as a as a portfolio manager focused on asset-backed and residential mortgage-backed securities. It was an overlooked rate in a sleepy corner of the market and nobody paid it much attention. That changed beginning in 2022, when monetary policy makers finally undertook the most aggressive rate-hike campaign in four decades to combat inflation — reinforcing the 2-year yield’s role as the best proxy for where the market thinks interest rates will end up. The 2-year yield rocketed to above 5% in early March from 0.15% in April 2021.
Suddenly, the 2-year Treasury became the most watched financial indicator on Wall Street, influencing the trajectories of stocks and the U.S. dollar throughout much of 2022. “This thing is relentless,” declared market commentator Jim Cramer on CNBC last year. He told viewers he was buying 2-year notes, not meme stocks. “The run to 4 is probably the most punishing one I can recall for the 2-year.” Other prominent names like Mohamed El-Erian, the former chief executive of PIMCO, and Jeffrey Gundlach, founder of DoubleLine Capital, wanted to talk about it. “If you want to know what’s going to happen in the year, follow the 2-year yield at this point,” El-Erian said on CNBC. “That’s the market indicator that has the most information.” More hedge funds and macro private-equity firms jumped on board and started trading it, said InspereX’s Petrosinelli. And head trader John Farawell of Roosevelt & Cross in New York, said family and friends who never showed much interest in fixed income before began regularly asking him if it was the right time to buy the 2-year Treasury note.
“Once we started to hit 4% on the 2-year yield last September for the first time since 2007, everyone got interested,” said Farawell, 66, a trader for the past 41 years. He estimates that interest in the 2-year yield among his firm’s clients has gone up about 30% in the past 12 months. “We have seen retail customers suddenly saying they want to put their money to work in the 2-year note because of an interest rate that we have not seen in years.”
From his office in Midtown Manhattan, Nicholas Colas noticed an abrupt and unexpected shift over the past year and it had to do with the 2-year Treasury. As the co-founder of DataTrek Research, a Wall Street research firm, Colas realized that the 2-year Treasury yield was influencing trading in the stock market. When the 2-year Treasury yield shot higher in 2022, the equity market would become volatile and often drop. In fact, the 2-year Treasury seemed to influence equity-market volatility in both directions. Whenever the 2-year yield briefly stabilized, Colas said, stocks tended to rally since equity investors took the stabilization in the 2-year rate to mean that Fed policy was “no longer as much of a wild card.”
To Colas, equity markets appeared to be taking any selloff in the 2-year note, and thus a rise in its corresponding yield, as a sign that the Fed would have to increase interest rates by more than expected and keep them higher for longer. With stocks and U.S. government debt both getting trounced regularly in last year’s selloffs, Colas said his first thought was that “all of a sudden, Treasurys were no longer a safe haven — something that has rarely happened since I started my career in 1983.”
Trading in government debt, like elsewhere in financial markets, is a two-way street of buyers and sellers. When yields are moving higher, that means the price of the corresponding Treasury security is dropping — and vice versa. The 2-year Treasury note pays out a fixed interest rate every six months until it matures. The trick to trading it, as opposed to buying and holding, is to either sell it before its underlying value gets destroyed by higher interest rates, or to buy it before the Fed starts cutting rates — which would, theoretically, produce a lower yield and make the government note more expensive.
Throughout the yield’s march higher, investors sold off the underlying 2-year note — a move which diminished the note’s value for existing holders like banks, pension funds, credit unions, foreign central banks, and U.S. corporations. Two-year Treasury notes also constitute about 1% to 2% of the total holdings at the 10 largest actively managed money-market funds, according to Ben Emons, senior portfolio manager and head of fixed income at NewEdge Wealth in New York.
“Policy expectations are what really drive the 2-year yield,” said Thomas Simons, a U.S. economist at Jefferies, one of the two dozen primary dealers that serve as trading counterparties of the Fed’s New York branch and help to implement monetary policy. “We had a major paradigm shift in terms of what investors’ expectations were for the sustainability of higher inflation and what the Fed would do in response. The impact on markets has been far less appetite for risk than there otherwise would be,” with stocks putting in a dismal performance in 2022, though generating somewhat better 2023 returns. Tucked into the note’s selloff, though, was plenty of interest from prospective government-debt buyers, which helped temper the magnitude of the 2-year yield’s rise once the rate got to 4%. Many looking to buy were individual investors hoping to benefit from higher yields and to diversify away from stocks, said traders like Tom di Galoma, a managing director for financial services firm BTIG.
Historically, banks, mutual funds, hedge funds, foreign investors and even the Fed have been the biggest buyers of Treasurys across the board; some of those players, particularly foreign central banks and money-market mutual funds, are mandated to buy and hold government debt. All two dozen primary dealers are involved as market makers for the 2-year security, stepping in to buy it in the absence of either direct or indirect buyers.
The 2-year note remains a reliable source of funding for the U.S. government, given the consistent demand for the maturity, which enables the U.S. Treasury Department to “raise a lot of cash quickly, if needed,” said Simons of Jefferies. In 2020, for example, when the government authorized $2.4 trillion in Covid-related spending and relief programs, the amount of 2-year notes sold at auction was one of the biggest of any maturity — far exceeding the 10- and 30-year counterparts — “because it had the capacity to handle that.’’
Sources: Treasury Department, Bureau of Public Debt, Federal Reserve Bank of Dallas.
Currently, the Treasury has $1.421 trillion in total outstanding 2-year notes, representing about 13% of all the debt issued out to 10 years, according to Treasurydirect.gov. The most recent 2-year note auction in March was for $42 billion — more than the 10-year note sale.
Fallout from the banking sector and worries about a potential recession altered the trajectory of the 2-year starting in March, triggering concerns that the Fed’s rate-hike cycle had gone too far. Fresh buyers poured into the 2-year space and pushed the yield below 4% — driven by the view that rates weren’t likely to go much higher from here and that policy makers might cut them by year-end.
Substantial downside volatility in the 2-year Treasury yield has actually helped to stabilize stock prices this year, in Colas’ estimation, because it’s been interpreted as the bond market’s sign that the Fed is approaching the end of its rate-hiking cycle.Like InspereX’s Petrosinelli, Colas says he had visions of the 2007-2008 financial crisis during March’s flight-to-quality trade, which occurred amid regional bank failures and “significantly more stress than the market was expecting.”
As of Thursday morning, the 2-year rate was at 4.17%, below the Fed’s benchmark interest-rate target range — implying that traders still believe policy makers will follow through with rate cuts. That’s a turnabout from the thinking that prevailed over most of 2022 through early last month, when the 2-year rate had been on an aggressive march toward 5% as the Fed continued to hike rates to combat inflation.
Meanwhile, poor liquidity continues to plague the Treasury market broadly, based on Bloomberg’s U.S. Government Securities Liquidity Index, which measures prevailing conditions. According to the New York Fed, the Treasury market was relatively illiquid throughout last year — making it more difficult to trade. As a result, there was a widening in the bid-ask spread — or difference between the highest price a buyer is willing to pay versus the lowest price a seller is willing to accept — of the 2-year note relative to its average.
“The volatility we’re seeing in the 2-year, we think, is largely a function of uncertain Fed rate hiking expectations coupled with poor liquidity,” said Lawrence Gillum, the Charlotte, N.C.-based chief fixed income strategist at LPL Financial.
“The 2-year is the most sensitive to changing policy expectations and since this Fed is ‘data dependent,’ any and all new data that could potentially change the inflation/economic growth narrative has increased volatility substantially,” Gillum said in an email. “As the Fed’s rate hiking campaign comes to an end (we think there is one more hike and then they’ll be done), we would expect the volatility to decline. Moreover, the Treasury and Fed are looking at ways to improve liquidity, but so far nothing has happened. Hopefully, they will do something, though, since the Treasury market is arguably the most important market in the world.”
At InspereX, Petrosinelli regards the 2-year note as an “anchor” to any short-term portfolio, and says that “it’s not a bad place for investors to hide out for at least a year.’’ That’s because even if the yield does come down, “investors wouldn’t be getting too hurt price-wise,” he said. “We think the Fed will leave rates elevated for some time.”
However, the 2-year could continue to dip below the fed-funds rate on soft economic data, especially related to consumption, later this year, Petrosinelli said. In order for the 2-year rate to go above the Fed’s main interest-rate target — now between 4.75% and 5% — “people would have to think the Fed is behind the curve again on inflation.”
For Farawell of Roosevelt & Cross, which was founded in 1946 and is one of Wall Street’s oldest independently owned municipal-bond underwriters, the 2-year note “has become such an attractive asset class for us’’ that “you almost can’t go wrong with putting money in it.” Friends and family “ask me about this 2-year and say, ‘It sounds good.’ I say, ‘It’s a great rate, you should buy it — until the Fed starts to change course.’”
