Bond Market Starting To Price in End To Rate Cuts?
A: Something that Rick Santelli over at the CME has been pointing out for days now on CNBC, is fairly significant. The bond market, and specifically the 2-YR Treasury yield, has been pricing in LESS ACTION from our fed lately which may signal we are nearing the end with rate cuts. With commodity prices surging and oil over $116/barrel plus good earnings news rallying the street, the street is awakening to the possibility that the fed's mindset will begin to shift from growth to inflation. If the fed gets more hawkish, which would encompass a range between only cutting by 1/4 point to a change in the statement to no cut at all in the next meeting, we would see a surge in the dollar and a likely drop in commodities priced in dollars. The question really should be, when will we see a rate hike?
Take a look at the 2-YR treasury yield over the past month (chart on right), up almost 70 basis points. In fact, yields are up across the board for treasuries, as the stock market rallied over 4% this week. The most dramatic action in the bond market was in the short end; 3mth, 6mth, 2yr & 3yr yields causing the so called 'flattening' of the yield curve. Now, while the curve isn't flat, it is flattening! This gives investors more incentive to cash out of longer term treasuries, and put that money to work elsewhere (stocks?). It also could be a sign that expectations are rising for less action from our fed, probably resulting from pipeline inflation pressures. Here is the general definition of a flat yield curve for all those that don't know.
Flat Yield Curve: When short- and long-term bonds are offering equivalent yields, there is usually little benefit in holding the longer-term instruments - that is, the investor does not gain any excess compensation for the risks associated with holding longer-term securities. For example, a flat yield curve on U.S. Treasury would be one in which the yield on a two-year bond is 5% and the yield on a 30-year bond is 5.1%.
Give Rick Santelli credit for calling this one earlier in the week, and telling viewers to watch out for the rising 2YR treasury yield; as when it got close to the rate of the fed funds rate of 2.25%, you will start to see confidence return to equities. Now its becoming a top story on business channels.
Whether this rise is a result of the re-adjusting LIBOR rate or from better than expected earnings which is rallying the stock markets, I don't know. But the 2YR is almost above the fed funds rate of 2.25%, and that means traders are betting on a more hawkish fed down the road. That is the angle I want to focus on here. I spoke often (here, here, and here, 4th comment) that when the fed sees less of a risk to economic growth, whether it be from all the stimulus thus far or that the economy is holding on better than expected, that they will 'take back' rate cuts rather quickly to combat inflation. Well, the bond market is starting to bet this way too. Since fed policy works at a lag, they may want to see how efforts so far fully affect markets and the economy.
If I were to look into the future, some questions that come to my mind if the bond market is right are:
Will the fed be forced to hike rates if lagging economic data is bad?
Will the fed cut less than expected OR not cut at all OR combination of rate cut but change in verbiage regarding future more hawkish policy?
What happens if housing/credit markets are not fully healed when the fed is forced to combat inflation by hiking rates?
How will equities react?
Something to keep an eye on! If the bond market is right on this, then we could be heading into a rate hiking campaign sooner than we originally thought! We may be risk adverse to keeping fed funds rate too accommodative for too long; especially after seeing the lessons learned from the Greenspan sponsored 1% fed funds rate for so long; that many now blame for causing the housing bubble. The fear is in the way the fed ultimately handles inflation pressures, given the housing/credit crisis; in other words, what if they tighten too soon hurting the eventual recovery!
