Peak Fed Rate Expectations? Using the 2-Year UST Yield to Time the Fed Pivot

Wed, May 25, 2022 - 2:35pm

In today’s piece, I will show how the 2-year US Treasury yield has operated as a guide for what to expect from the Federal Reserve and reiterate our outlook for a potential Fed pause in rate hikes around the fall timeframe, which may coincide with a more sustainable market bottom.

The well-known strategist Jeff Gundlach has argued that we should do away with the Federal Reserve and replace the fed funds rate with the 2-year US Treasury (2yr UST) yield given its track record for where the Fed funds rate should, or is likely to, move.

Typically, when we see the 2yr UST yield dip below the upper bound of the fed funds rate, this signals an incoming pause or lowering of rates, as we saw during the last five tightening cycles.

1986-1989 Cycle

86 tightening cycle
Source: Bloomberg, Financial Sense Wealth Management

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1993-1995 Cycle

93-95 tightening cycle
Source: Bloomberg, Financial Sense Wealth Management

1999-2000 Cycle

99-2000 tightening cycle
Source: Bloomberg, Financial Sense Wealth Management

2004-2006 Cycle

2004-2006 tightening cycle
Source: Bloomberg, Financial Sense Wealth Management

2015-2018 Cycle

2015-2018 tightening cycle
Source: Bloomberg, Financial Sense Wealth Management

2022 Cycle (Today)

Currently, the 2yr UST yield is roughly 1.5% above the Fed’s target rate but if the Fed sticks with its 50 basis point hikes (50 basis points = 0.5%) in the next two meetings as expected, the Fed target rate will be 2% by July and only 50 basis points below the current 2yr yield. Should the 2yr UST yield continue to dip, we may see it fall below the fed funds rate by August/September, which is a good time to expect a pause in tightening.

2022 tightening cycle
Source: Bloomberg, Financial Sense Wealth Management

What About Rate Cuts?

To help gauge the timing of actual rate cuts, I did a study back in June of 2019 (Policy Misstep Déjà vu?) to see how long after the 2yr UST yield dipped below the fed funds rate by 50 basis points (bps) did it take for the Fed to cut rates outside of recessionary periods. Since the 1981-1982 recession, every time the 2yr UST yield dipped below the fed funds rate by 50 bps or more, the Fed cut interest rates within 1 year, no exceptions. The typical lead time was just under 2 months, where 2006 was an outlier as the spread between the 2yr and fed funds rate didn’t materially widen until 2007, well after the initial spread widened to -0.50%.

2yr yield less fed funds rate
Source: Bloomberg, Financial Sense Wealth Management

With the above in mind, I argued in June 2019 that the Fed would likely move to rate cuts, which it did on July 31, 2019. Given the track record of the 2yr UST yield in predicting Fed policy, we need to watch it closely in the weeks and months ahead. If it falls to 2%, which is where the fed funds is expected to be after the July meeting, the Fed is likely to be strongly hinting at a pause. As well, if the 2yr yield dips below 1.5%, actual Fed rate cuts may be in the offing with a potential recession in store for 2023 as 5 of the 6 tightening cycles cited in the table above landed in recession.

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Copyright © 2022 Chris Puplava

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chris [dot] puplava [at] financialsense [dot] com ()