Bank woes raise questions about the Fed’s next move.
Investors’ sudden hunger for U.S. government bonds has pushed yields to their lowest levels in months—and created much uncertainty about what happens next in the Fed’s battle against inflation.
In a notable move, the yield on the 2-year Treasury plummeted 106 basis points from last Wednesday’s close through Monday’s close—the second largest three-day decline in the T-note’s yield over the last 40 years (see the chart). The 2-year Treasury yield now sits at its lowest level of the year.
Yields went into freefall as investors, fearful that fallout from Silicon Valley Bank’s collapse last week could spread throughout the banking sector, raised doubts that the Fed will continue with its current pace of interest rate hikes when it meets later this month. Until this recent financial shock, investors largely agreed the Fed would raise rates in March by at least 25 basis points in its continued efforts to stamp out high inflation. Now, some on Wall Street think the Fed will hit pause as it assesses the impact of recent events–or even reverse course.
Example: Last week, it was estimated that the Fed would raise rates four times between late December 2022 and the end of 2023. As of Monday’s close—just a few days later—the market was expecting the Fed to cut interest rates three times by year-end.*
Concerns about the financial system’s health also drove investors to scoop up high-quality government bonds, putting further downward pressure on those bonds’ yields (as bond yields decline when bond prices rise.)
The upshot: We’re in murkier waters than we were just a little more than a month ago. Back then, we noted that the financial markets were predicting lower volatility in the 2-year Treasury yield going forward. That’s not the case today. And if the yield on an essentially risk-free asset like a short-term Treasury note ends up fluctuating wildly, it becomes virtually impossible to accurately value equities with any degree of confidence.
New data to be released before the next Fed meeting may offer some clarity about the direction of rates. For now, however, we believe the extreme sentiment shifts we’re seeing in the wake of the Silicon Valley Bank failure mean it’s likely a good time to exercise caution.
*Federal Funds rate estimated using Bloomberg’s World Interest Rate Probabilities (WIPR). WIRP is a statistical function developed by Bloomberg that uses fed funds futures and options to infer the implied probability of future FOMC decisions.
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