The bond market is challenging the Fed to a game of chicken.
After seven years of keeping the fed funds rate near zero, the Fed embarked on a rate-hiking cycle at the end of 2015, raising the fed funds target rate nine times in three years, from 0.25% to 2.50%.
Over that period, the yield on the 2-yr Treasury always closed above the target rate. It came close to breaking below it in July 2016 and again in September 2017, but quickly reverted higher both times.
The last day of 2018 was the first time that the 2-yr yield breached the fed funds target rate since 2013. Since then it has trended lower and, as of May 15, 2019, has been below the target rate for 50 consecutive trading days.
In addition to the picture painted by the fed funds futures market, this low 2-yr yield level is another strong indicator of the market’s expectation for a fed rate cut before the end of 2019.
If this development is noteworthy without any additional context, the concurrent factors opposing it make it downright odd.
At an early-May press conference, Fed Chairman Powell noted, “We do think our policy stance is appropriate right now. We don’t see a strong case for moving in either direction.”
The following week, the release of CPI data showed that annual inflation had risen to 2.0%.
Nevertheless, (presumably in response to the deteriorating trade talks between the US and China), the 2-yr Treasury yield closed 30 bps below the target rate on May 15.
Assuming an overnight rate can’t long remain above a 2-year rate, it will be interesting to watch in the coming weeks and months whether it will be the Fed or the bond market that will be first to give in.
Unless otherwise noted, data is sourced from Bloomberg.
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