Treasuries Ain’t Buying What The Fed’s Selling

By Kevin Flanagan

While the outcome of the December FOMC meeting did not offer any big surprises, the U.S. Treasury (UST) market’s response has left some feeling a little perplexed. On the surface, the results tilted more “hawkish,” if anything, but UST yields have remained little changed in the days immediately following the Fed’s final gathering of the year. As a result, one can’t help but think the UST market just ain’t buying what the Fed’s selling.

I’ve received a ton of questions, like what is behind the UST market’s odd response to the Fed meeting. So, I went back for another look to see if I was missing anything, and here’s what I came up with:

• The Fed not only raised the Fed Funds target range by 50 basis points (bps) (an outsized increase), but it also signaled more is on the way.

• The FOMC policy statement was essentially unchanged, with the phrase “ongoing increases in the target range will be appropriate…” remaining in the text. There was some thought that this phrase could be “watered down,” but it obviously wasn’t.

• The policymaker raised its 2023 median estimate for Fed Funds (dot-plot) to 5.1% versus September’s figure of 4.6%. It even bumped up the 2024 level to 4.1% from 3.9%.

• While its growth forecast for 2023 was downgraded, the Fed’s projection has no recession in 2023.

• Powell’s presser emphasized that policy is expected to stay on an extended hold once rate hikes are done, and no rate cuts will be coming until he’s confident inflation is moving toward 2%.

Taken together, it would have been reasonable to expect UST yields to rise in this setting, especially for shorter-dated maturities such as the 2-Year note. In fact, in what is perhaps the first time on record, the current UST 2-Year yield is residing below the Fed Funds trading range, at 4.19% versus 4.25%-4.50% (as of this writing), while the Fed is actively considering further rate hikes.

That brings us back to the aforementioned question. In my opinion, it has become increasingly apparent that the UST market does not think the Fed will push Fed Funds to its new 5.1% target. Inflation seems to be cooling, and the expectation is that economic data will soften to the point that Powell will have to change course sooner rather than later. Interestingly, we have seen Powell pivot quickly already this year, just the other way around. In fact, you could certainly make the argument that Treasuries have already factored in a no-growth/recession for next year.

Conclusion

Where does that leave us to end 2022 and begin the new year? In my opinion, labor market data will return to its center-stage role next year and be the key determinant in whether the UST market is correct in its current thinking or whether the Fed actually does what it is presently stating it will do. I can see a scenario where the jobs numbers don’t soften sufficiently in the opening months of 2023, and the Fed does bring the terminal rate up toward the 5% threshold and goes on an extended pause. Against that backdrop, UST yields would seem to be vulnerable to some upside pressure. However, as Q2 rolls around, the Fed will end its rate hikes, economic data will weaken, and a bond market rally could very well follow suit.

Kevin Flanagan, Head of Fixed Income Strategy

As part of WisdomTree’s Investment Strategy group, Kevin serves as Head of Fixed Income Strategy. In this role, he contributes to the asset allocation team, writes fixed income-related content and travels with the sales team, conducting client-facing meetings and providing expertise on WisdomTree’s existing and future bond ETFs. In addition, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was most recently a Managing Director. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management’s monthly and weekly fixed income publications, and collaborated with the firm’s Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University’s Lubin Graduate School of Business, and a B.S in Finance from Fairfield University.

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