Who is Going to Chicken Out First? Insights From The Fed Funds Rate and Treasury Yields

January 19, 2023 | InsiderSentiment.com Team

Powell's battle

Markets are having an interesting fight with the Fed these days.  It seems that they have forgotten the old dictum, ‘Don’t fight the Fed.’  The Fed is trying to push up interest rates by raising the Fed Funds rate while markets are pushing down yields. The market thinks the Fed will be forced to pivot, and hence interest rates will go down, and therefore are pushing yields down by buying bonds. 

So who is likely to come out on top, and who is likely to chicken out first, the Fed or the market?  For the Fed, chickening out would mean dropping the Fed Funds rate toward 4.1%, while for the markets it would mean increasing the yield on the 2-year Treasury note up to 4.5%, then 4.75%, and eventually to over 5%. Let’s take a deeper dive into this question and see which is more likely.

What is the Current Plan for the Fed Funds rate?

Fed officials have aggressively raised the Fed Funds rate in 2022, with currently the top end of the target rate sitting at 4.5%, and poised to rise to 4.75% in February, and then 5% in March.  Federal Reserve Bank of St. Louis President James Bullard said the US central bank should raise interest rates above 5% expeditiously to ensure price pressures are subdued. Bullard favors a 50 basis point rise in February.  Furthermore, according to the median Fed official projections, the Fed Funds rate is expected to rise to 5.1% later this year.  Fed officials have repeatedly said that there will be no pivot in 2023.  The rate will stay at the terminal rate until inflation falls to 2%.

What Does the Market Expect for the Fed Funds Rate?

Now contrast this tough Fed talk with the market's actions.  According to futures markets, the 90-day Fed Funds rate maxes out at 4.86% in June and falls to 4.24% by December 2023. The likelihood of 50 basis point rise in February is less than 5%, according to the futures markets.   The markets actually believe that the Fed will be cutting rates during the second half of 2023.

How Have the Market and the Fed Disagreed Historically?

To get some historical perspective on what happens when the Fed and the markets disagree, see the chart below, which plots the constant-maturity 2-year Treasury Note yield (blue line) against the effective Fed Funds rate (red line).  Let’s take a closer look at what the data says.  In the mid-1980s, 2-year Treasury yields peaked at 13.17% in June 1984 and started declining, while the Fed funds rate peaked two months later in August 1984 at 11.64% and then started declining.  In the early 1990s, 2-year Treasury yields bottomed at 3.7% on October 5, 1992 and started rising, while the Fed funds rate bottomed two months later in December 1992 around 2.9% before rising.  In the mid-1990s, 2-year Treasury yields peaked at 7.7% in December 1994 and started declining, while the Fed funds rate peaked four months later in April 1995 around 6.1% and then started declining.  More recently, 2-year Treasury yields peaked at 2.98% in November 2018 and started declining, while the effective Fed funds rate peaked five months later in April 2019 around 2.4% and then started declining.  

Graph showing the Fed Funds rate versus 2 year Treasury yields

The lessons for history indicate that 1) The effective Fed Funds rate closely follows the 2-year Treasury Note yield; 2) When they disagree, the effective Fed Funds rate reverts back to the 2-year Treasury yield, and 3) The 2-year Treasury yield does not chase after the Fund Funds rate.

The Takeaway on the Fed Funds Rate vs Treasury Yields

It seems the historical lesson is clear:  Collective market wisdom clearly trumps Fed talk.  Currently, the 2-year Treasury Note yield is at 4.1% (as of January 18) and falling while the Fed Funds target rate is at 4.5% and expected to rise. Once again, there is a sharp disagreement.  The historical record suggests that the direction of the 2-year Treasury yield is a much better indicator of the future direction of the interest rates than the Fed Funds rate.  

Why does market wisdom beat out the Fed, you might ask?  The Fed is obviously subject to political pressures.  It worries about establishing or losing credibility.  The Fed may persist with its errors simply because of what it did or what is said recently.  Markets, on the other hand, have no such worries.  They put their money where the data point to.  They follow the data without emotions or worries about their reputation.

Based on the historical record, we expect the Fed to stop raising rates soon.  Furthermore, we expect the Fed to start cutting rates by the middle of the year, just as market participants expect.  The trigger for such a pivot will be weakening economic outlook and impending recession.

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