Updated: 10-15-2018

Reading Tea Leaves of the 2-Yr Note
Updated: 08-Oct-18  03:39PM ET
Analyst: Pat O'Hare

The Federal Reserve has been raising the target range for the fed funds rate. Everyone knows that, especially anyone with variable rate debt or anyone who is contemplating taking out a loan. The Federal Reserve isn't done raising the target range for the fed funds rate either -- or so it now thinks.

The target range for the fed funds rate sits at 2.00% to 2.25% and it should be going to 2.25% to 2.50% at the December FOMC meeting. If things unfold like Fed members expect them to, it is thought that the fed funds rate will be raised three more times in 2019.

Given that outlook, it stands to reason that the 2-yr note has had a tough go of it in 2018. Its travails -- and the work of the Federal Reserve -- have hit home in the 2-yr note, which has seen its yield increase 97 basis points since the start of the year to 2.88%.

That move has captivated the market, but lately, it has been the move in longer-dated securities that has really caused a stir.

In October, the 10-yr note yield has climbed 18 basis points to 3.23% and the 30-yr bond yield has jumped 21 basis points to 3.40%. The 2-yr note yield, meanwhile, has increased "only" eight basis points in what has been a "bear steepener" trade.

The rapid uptick in rates at the back of the curve has unsettled the stock market and has piqued concerns about the pace of future economic growth.

In turn, there are burgeoning concerns that longer-dated rates may be going much higher yet as inflation pressures pick up with a tightening labor market, tariff actions, deficit funding, technical selling, and the Federal Reserve's balance sheet normalization efforts.

No one can say for certain how high longer-dated rates are going to go from here. One of the best gauges, though, for determining when the Treasury market thinks longer-dated yields have risen too far will be the 2-yr note yield.

It should diverge from longer-dated instruments as investors become convinced that higher long-term rates will indeed crimp economic activity.

Why would it diverge? Because there would be an assumption that a slowdown in economic activity brought on by higher long-term rates is going to induce a slowdown, and maybe even a halt, in the pace of interest rate hikes from the Federal Reserve.

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