Over the last few months, we have been noting the shape of the U.S. Treasury yield curve. Expectations for more rate hikes increased as the Fed continued to be hawkish, and the curve inversion worsened. The long end is being driven by a decelerating economic outlook while the front end is more responsive to Fed policy.
With that dynamic in mind, we will review the shifts we have observed in the data. Since the November FOMC meeting, the Fed has hiked 150 basis points from 3.25 to 4.75. The Fed maintained its hawkish position and expressed the need for more rate hikes. The Fed Funds futures market continued to price in a higher terminal rate, but the overall U.S. Treasury yield curve remained inverted. The front-end increased on rate hike expectations, while the long-end was anchored on expectations for economic growth and inflation. Looking at one example within the curve during that period, the 3-month Treasury bill increased 63 basis points and the 10-year declined 50 basis points. The 3m10y curve, which tends to invert in periods leading up to economic slowdowns, has been inverted since the end of October and flattened to record lows over the last two months. The shape of the curve has likely been signaling some version of an economic slowdown while the Fed remains focused on lagging economic indicators.
Last week we saw a notable shift in the Fed Funds futures market. On March 8th, the day Jerome Powell spoke, the expected terminal rate increased to 5.70 by September 2023 with no full rate cuts priced in by year-end. However, the 3-month declined from Wednesday through Friday, and the 10-year declined by more, pushing the 3m10y curve to a record low of -131 basis points. By March 10th, the terminal rate declined to 5.27 by June 2023 – a 50 basis point reversal in terminal rate expectations in two days with a 25 basis point rate cut by November 2023 and an additional 30 basis point cut by January 2024. Something changed the view within the Fed Funds futures market, but the shape of the yield remained the same.
By the close on March 13th, Fed Funds futures were pricing in a terminal rate of 4.75 in May 2023, a 25 basis point cut by June 2023, followed by a 50 basis point cut in July 2023, and a 25 basis point cut by January 2024. From February 28th through March 13th, the Fed Funds futures market shifted from almost 100 basis points of hikes through September 2023 with a terminal rate of 5.70 to almost 100 basis points of cuts by January 2024 without moving above the current target rate of 4.75.
Leading up to the March 8th Powell presser there seemed to be less uncertainty around the pace and level of rate hikes. In the last few days that has changed. The increased uncertainty in Fed policy has led to an acceleration in overall Treasury volatility. One way to measure that volatility is to track the MOVE Index. On March 13th, it closed at 174, up 34 points day-over-day marking its sixth largest one-day advance on record. Jumps of this magnitude and the absolute level of volatility have typically occurred in periods of economic weakness.
Click image to enlarge.
One takeaway from these recent changes is the increased uncertainty around Fed rate hikes. The larger takeaway in our view is that the shape of the yield curve has been suggesting a reversal of current policy as economic activity decelerates.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Senior Economic Analyst
Boyd Watterson Asset Management, LLC