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The 2-year note has a view on the Fed’s next move

| March 29, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

All four times since 1994 that the yield on the 2-year Treasury note has dropped below the fed funds target rate, the Fed has cut the target within 18 months. And without that inversion, the modern Fed has never cut. With the 2-year yield now nearly 25 bp below the funds target, the market has shown its conviction on the Fed’s next move.

It’s no surprise that the Treasury curve constantly tries to anticipate the Fed, but the track record of the 2-year note is, well, notable. Ever since the Fed first announced a target rate in 1994, inversion between the target and 2-year yields has predicted every cycle of cuts (Exhibit 1). Investors in 2-year notes, after all, have to weigh the alternative of a rolling investment in Treasury bills or similar short instruments heavily influenced by the Fed’s path. The 2-year note should constantly price to at least break even against the expected funds.

Exhibit 1: Seeing 2-year yields below fed funds has signaled all cuts since 1994

Source: Amherst Pierpont Securities

The aftermath of seeing 2-year yields drop below the target has not always been the same, however. Starting from the 1995-1996 cycle of cuts, the time the market had to wait between the first inversion and the first cut has generally lengthened. The average and maximum inversion during the subsequent cycle has deepened. And the market arguably has improved its ability to anticipate the last cut.

Starting with the 1995-1996 easing cycle, the funds-to-2-year inversion came less than two months before the first cut. In 1998, the inversion came nearly nine months before the first cut. Inversion came nearly seven months before the first cut of 2001-2002. And the 2007-2008 easing cycle saw inversion more than 14 months before the first cut.

Once the funds-to-2-year rate inverts, it tends to stay inverted through the easing cycle. Inversion during 1995-1996 averaged 14 bp with a maximum of 50 bp. The average rose in 1998 to 22 bp with a maximum of 123 bp. The average rose again in 2001-2002 to 41 bp with a maximum of 164 bp. And the average peaked in 2007-2008 at 67 bp with a maximum of 190 bp.

The market also seems to have improved its ability to anticipate the end of an easing cycle. In the 1995-1996 and 1998 cycles, 2-year yields still stood below the fed funds target the day after the last cut. But by the 2001-2002 and 2007-2008 cycles, 2-year yields had jumped above target funds by the time of the last cut.

Other work has highlighted inversion in short rates rather than long rates as a predictor of market events. The NY Fed recently noted the strength of the inversion between the current 3-month Treasury bill and the implied rate on bills 18-months forward as a predictor of recession. The inversion between target fed funds and 2-year yields may have some information about implied recession, but it likely says more about the Fed’s policy aspiration to ward off recession. That’s likely a more accurate read on what the current inversion implies.

***

The view in rates

The market continues to revise down its expectations for US growth, and recently, inflation, and it all rolls up into the current 2.40% 10-year rate. The 10-year real rate of 0.53%, which arguably implies growth around 1.0%, looks too low. Breakeven inflation of 187 bp also looks a little light. The market may need to see several quarters of steady rather than declining growth to buy the consensus among economists that growth will plateau around 2.0%, but that looks very likely to happen. Fair value on 10-year notes is somewhere above 2.75%. Look for longer rates to rise from here.

The 2.26% rate on 2-year notes has has built in at least two Fed rate cuts in the next two years. That seems more of a growth than a recession concern. The Fed could easily cut if growth shows any sign of slowing below 2.0%.

With the yield curve flat between 2- and 7-year maturities and upwardly sloped beyond, investors will have to pick their yield curve spots carefully, especially when it comes to hedging.

The view in spreads

In general, low volatility and heavy net Treasury supply should help spread products tighten. The corporate market still has issues with leverage in investment grade debt and loose underwriting in leveraged loans; a slowing economy should put pressure on those sectors. Agency MBS should broadly outperform corporate debt.

The view in credit fundamentals

Household balance sheets continue to look strong, but corporate balance sheets have started to do some work, too. Companies have started to divert cash flow toward paying down debt, have started to sell non-core assets and have curtailed stock buybacks. The ratio of household debt service to disposable income is at a record low, corporate leverage at a relative high. The Fed has signaled that it stands ready to buffer any material softening in growth.

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