In One Chart: Why a plunging 2-year Treasury yield may be screaming Fed ‘policy mistake’

by | May 4, 2023 | Stock Market

The Treasury market is sending up a warning flare, indicating the Federal Reserve may have made a “policy mistake” Wednesday as it continued to hike rates into an economic slowdown and a banking scare, a closely followed Wall Street analyst warned. “Yesterday’s Fed decision was the 2nd rate hike which propelled 2-year yields (forward-looking indications) LOWER as the Fed raised rates. Historically, divergent paths between Fed Funds and 2-year indicate a policy mistake,” said Jeff deGraaf, founder of Renaissance Macro Research, in a Thursday note (see chart below).

Renaissance Macro Research

The yield on the 2-year Treasury note
declined more than 20 basis points on Wednesday to 3.751%. Yields move in the opposite direction of price. Stocks were under pressure on Thursday, with the Dow Jones Industrial Average
slumping around 300 points, or 0.9%, while the S&P 500
lost 0.5% as both indexes threatened to extend a losing streak to four straight sessions. Worries over the banking sector and a potential recession continue to dog equities, analysts said. The Federal Reserve on Tuesday delivered its 10th consecutive rate increase and indicated that a breakneck cycle of hikes may be due for a pause depending on incoming data, but Chair Jerome Powell said rate cuts remained at odds with the central bank’s inflation outlook. See: Traders ignore Powell and begin pricing in a Fed rate cut as soon as June In 2021, it was a surge in the 2-year yield that signaled the Fed had fallen behind the curve, keeping rates low as inflationary pressures built up. DeGraaf noted that 2-year yields broke out in June 2021, nine months ahead of the Fed’s first rate hike in March 2022. Policy mistakes “always manifest themselves through the short-end of the yield curve,” deGraaf said. He noted that when the 2-year yield peaked above the 5% threshold in March of this year, the top of the fed-funds rate was at 4.5%, now the 2-year yield is near 3.8% while the fed-funds rate is at 5% to 5.25%. “History does not look kindly upon these aggressive policy measures that vary wildly from the market’s message,” deGraaf warned.

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