What's Going On In The Treasury Market?

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by: Wolf Richter

The Fed's new paradigm.

The three-month Treasury yield closed at 1.81% on Friday. It has been at about this level since before the Fed's March 21 meeting, when it hiked its target range for the Federal Funds rate to 1.50-1.75%. In other words, the three-month yield had been trading above the upper limit of the Fed's range even before it was announced. So the rate hike was fully priced in, plus some, in preparation for another rate hike in June. This is up from 0% in 2015 when lots of folks said that the Fed could never raise interest rates again.

The two-year yield had no such moment of rest. It rose to 2.46% on Friday, the highest since August 11, 2008, and up from 2.31% on rate-hike day in March:

As bond yields rise, bond prices fall by definition. So a rising-yield environment can be tough on holders of bonds with longer maturities.

Ten-year Treasury yields moved only sporadically, wavering, or even declining as short-term yields soared, but then shot higher, before taking another break. Now it's shooting higher again.

On Friday, the 10-year yield rose to 2.96%, the highest close since January 9, 2014. It's tantalizingly close to 3% and appears to be setting up for another try at breaking the 3% level. If the 10-year yield closes at 3.05% - just 9 basis points higher than Friday's close - it will be the highest close since July 2011:

In mid-February, as the 10-year yield was soaring and threatened to take out the 3% level, I speculated that it would run into a wall over the near term, for two reasons: Enormous demand at the 3% level, and record short positions by hedge funds against the 10-year Treasury. This begged for a contrarian rally, or even a short squeeze. While the ensuing rally wasn't exactly spectacular, it pushed the yield down to 2.73% by early April. But since then, the 10-year has sold off again. Now with the yield at 2.96%, it might try to make another run at breaking 3%.

It might not succeed this time. But it will succeed sooner rather than later. Of note, the two-year yield has not yet run into this kind of wall of resistance as of yet.

As in the prior three rate-hike cycles going back to the 1990s, the two-year yield has reacted faster to rate hikes than the 10-year yield. While the 10-year yield tends to surge later in the cycle, the two-year yield also surges and has a tendency to overshoot late in the cycle.

The current spread between the two-year yield (2.46%) and the 10-year yield (2.96%) is 50 basis points, about the same as in December. That spread is narrow. But this is practically normal in rate-hike cycles.

The chart below compares the two-year yield (black line) and the 10-year yield (red line) going back to 1992. We're now in the fourth rate-hike cycle over the period. Note how much jumpier the two-year yield is than the 10-year yield (click to enlarge):

The two-year yield was higher than the 10-year yield in 2000 and then again in 2006/2007. This was when the yield curve "inverted," the unusual phenomenon when the 10-year yield is lower than shorter-term yields.

But this rate-hike cycle is different from the prior ones. The last rate-hike cycle started in June 2004 and ended in June 2006. During those two years, the Fed took its policy rate from 1% to 5.25%.

This time, the Fed is moving at a glacial pace. If it hikes rates by 25 basis points four times this year, it will be a lot. In this cycle, the Fed has engaged in policy action only at meetings that are followed by a press conference. There are four of them per year.

The Fed started in December 2015 with a 25-basis-point hike, did another one in December 2016, did three in 2017, and might do four in 2018. For now, it is set to proceed at a similar pace in 2019 and possibly into 2020. At this pace, the rate-hike cycle might last up to five years - instead of two years. The Fed's persistent word for this has been "gradual."

Given that the pace is so much slower, and that the duration of the cycle is already longer than the 2004-2006 cycle, the results will likely be different too. The last two rate-hike cycles ended in inverted yield curves and were followed by recessions and worse.

This pattern might not occur again - given the Fed's new paradigm, the slow-motion approach. And we're left guessing as to how this might turn out. If the economy adjusts to these higher rates without recession, the Fed might not cut rates again for a long time, even as asset prices - stocks, bonds, real estate, etc. - "gradually" meander lower for years in response to higher rates and tighter credit. Think about the implications.

The bond market is already talking about the next rate cuts, possibly as soon as 2019, much like it was talking about "QE Infinity" in 2012 or the permanent zero-interest-rate policy in early 2015. And given the new scenario of long slow-motion rate hikes, the bond market may be engaging in wishful thinking once again.

The two-year yield, now surging, is a leading indicator. Read… "Financial Stress" in the Credit Markets v. the 2-Year Yield