Friday, January 27, 2023
The spotlight will shift from earnings to the Federal Reserve (Fed) next week as they wrap up their 2-day monetary policy meeting on Wednesday, February 1. Market expectations are set for an increase of 25 basis points (bps) in the fed funds rate, which would shift the Fed’s target range up to 4.50%–4.75% from 4.25%–4.50%. There will be no updated Summary of Economic Projections accompanying the meeting, leaving investors to sift through the policy statement and Chair Powell’s post-meeting press conference for any potential clues on the path of future policy.
One of the big questions going into next week is if this could be the last rate hike of the cycle. As of this morning, Friday, January 27, the fed funds futures market is pricing in an 82% implied probability for an additional 25 bps rate hike in March. While LPL Research also expects another 25 bps increase in March, there is evidence in the Treasury market that suggests the end of the cycle may be closer than we think.
The chart below shows benchmark 2-year Treasury yields compared to the upper bound of the Fed’s target range. As you will notice, 2-year yields are highly correlated to the path of monetary policy, given their short duration. In the bottom panel, the spread between the 2-year Treasury yield and the upper bound of the Fed’s target range is shown. The arrows in both panels represent crossover points when the 2-year Treasury yield crossed below the upper bound during a rate hike cycle. The shaded red panel represents U.S. recession periods.
Since early November, yields have dropped around 50 bps to 4.19% as of January 26. Lower yields have been a product of receding pricing pressures and reduced expectations for Fed tightening. While yields violated an uptrend amid their current pullback, they also dropped below the upper bound of the Fed’s target range. This crossover occurred despite Fed commentary suggesting ‘there is more work to do’ in order to bring down inflation. However, the market appears to be pricing in an end to the rate cycle perhaps sooner than the Fed suggests. Of the last five rate hike cycles shown, crossovers below the upper bound typically occurred at or near the end of a rate hike cycle (although there was an early signal in 1988).
What do these crossovers mean for markets? We analyzed forward price action after each crossover going back to the late 1970s. The table below breaks down the forward net changes in the upper bound of the Fed’s target range, the 2-year Treasury yield, and the percentage changes of the S&P 500 following each crossover during this timeframe.
A few key takeaways:
- The upper bound of the Fed’s target range generally remains flat to lower over the proceeding 12-month period. This trend has been especially consistent over the last five major rate hike cycles going back to 1989, as each crossover signaled a pause and/or start to rate cuts.
- There was an early signal in 1988 and also mixed results in the late 1970s and the early 1980s.
- On average, 2-year Treasury yields traded lower across each period with few positive net changes recorded during the three-, six-, and 12-month timeframes.
- The S&P 500 historically struggled after the first month following a crossover. However, returns materially progressed as the index posted 12-month respective average and median gains of 15.37% and 22.43%. The index also finished higher 80% of the time during this period.
In summary, the recent crossover of the 2-year Treasury yield below the upper bound of the Fed’s target range suggests the rate hike cycle could be near completion. This does not imply the Fed will immediately start cutting rates, but does perhaps alleviate some fear over a further prolonged rate hike cycle. Historically, crossovers have also been a good sign for equity markets based on above-average returns following each signal for the S&P 500.
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