Several U.S. Treasury yields are trading below the Federal Funds Target Rate.

For most of 2022, U.S. Treasury yields followed the path of Fed rate hikes. Yields at the front end of the curve moved higher on anticipation of more rate hikes, but the long end of the curve moved up by less, which resulted in a flattening of the 2y10y and 3m10y curves. The front end of the curve is more heavily influenced by the Fed Funds rate, while the long end of the curve reflects long-term expectations for growth and inflation.

Halfway through the year the long end started to fall as front-end rates moved up, and in July the 2y10y curve inverted. Following the August FOMC meeting, yields moved up across the curve, but again long-end rates did not match the pace of the front end and the 2y10y remained inverted. A few days before the November FOMC meeting, the 3m10y curve inverted. Long-end rates fell despite the 75-basis point rate hike. Since that meeting, both the 2y10y and 3m10y made new cycle lows reflecting an increased probability that some version of a negative economic environment may be unfolding. The 5-Year through the 30-Year have traded below the target rate since that November meeting. Following the December rate hike, the 2-Year has also traded below the target rate. U.S. Treasury yields should be higher than the Federal Funds target rate in a normal economic environment.

Source: Macrobond.

Historically, yields began to fall below the target rate near the end of the hiking cycle. Then, front-end yields fell quickly when the Fed started to cut rates. The charts below are examples of this setup leading up to the 2008, 2001, and 1990 recessions. The commonality in these three cycles is that all yields dropped below the target rate at the beginning of the last pause before cuts began and never collectively fell below the target rate before that pause.

Source: Macrobond.

The Fed Funds Futures market is currently pricing in a target rate of 5% by June 2023. The next FOMC meeting is January 31. Until then, we will continue to monitor yields relative to the current and projected Federal Funds target rate.

 

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