Treasury Yields Surge Ahead of Rate Hike Expectations

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Yields on the 2-year Treasury note rose to 1.308%, the highest since August 2009

Two-year Treasury yields have surged to the highest level since 2009 after the market-based probability that the Federal Reserve will raise rates in March 2017 has soared, as reported by Bloomberg on March 01st, 2017. Over the last three days, bond traders have moved to catch up with the Fed’s view, pricing in what amounts to an additional half a hike by year-end. Yields on the 2-year Treasury note, which is more sensitive to monetary policy changes, rose to 1.308%, their highest since August 2009. The jump in the 2-year yields put the spread between US 2-year Treasuries and German 2-year bunds on pace for its highest closing level since 2000.

Longer-dated Treasuries also saw substantial selling after the release of January’s personal consumption expenditure, or PCE, data that showed the Fed’s favored measure of inflation posting its largest monthly increase in four years. The yield on 10-year notes rose to 2.471%, the highest since February 16th, 2017. Prices on 30-year bonds fell by more than 2 points, pushing yields to 3.074%, the highest since February 16th, 2017.

On February 28th, 2017, San Francisco Fed President John Williams and New York Fed President William Dudley gave a hint to traders about the central bank’s urgency to tighten. Williams said policy makers will give “serious consideration” to a rate boost on the Fed’s next meeting on March 14th-15th, 2017, adding that he does not see a need to delay the next move. Dudley said the case for tightening “has become a lot more compelling.”

Economists and industry watchers see a 50-50 chance that the Fed boosts rates in March 2017, after previously ruling it out. Goldman Sachs Group Inc.’s (NYSE: GS) economists upped the probability of a move this month to 60% from the earlier level of 30%. ABN Amro Bank N.V. pulled forward its estimate for the next hike to March 2017.

Fed Chairperson Janet Yellen told the US Senate Banking Committee on February 14th, 2017, that the Federal Reserve will likely need to raise interest rates at an upcoming meeting, although she flagged considerable uncertainty over economic policy under the Trump administration. Yellen said that delaying rate increases could leave the Fed’s policymaking committee behind the curve and eventually lead it to hike rates quickly, which she said could cause a recession. Yellen did not specify when the next rate hike would happen, but said that the Federal Open Market Committee (FOMC) would evaluate whether employment and inflation are evolving in line with its expectations before hiking rates again.

Since the end of the 2007-09 recession, the Fed has raised rates in December 2015 and again in December 2016. The FOMC, which met in Washington on December 13th-14th, 2016, increased its benchmark rate by a quarter percentage point to a range of 0.50% to 0.75% for the first time in 2016. The Fed has also indicated that it expects to hike rates three more times in 2017, two or three in 2018, and three in 2019, as inflation expectations have increased considerably along with the strengthening of labor market conditions. New projections show that central bankers are expecting three quarter-point rate increases in 2017, up from the two seen in the previous forecasts in September 2016. Meanwhile, Fed officials have reiterated that near-term risks to their outlook are roughly balanced, while projecting three quarter-point rate increases in 2018, based on median federal funds forecasts of 1.375% in 2017 and 2.125% in 2018.

Futures traders shift direction

Futures traders are shifting in a similar direction as that of bond traders over the past few days. The market-implied probability of a March hike soared to 82% from 40% at the end of last week, based on the assumption that the effective fed funds rate will trade at the middle of the new FOMC target range. Using the current effective rate of 0.66% and the forward OIS rate for the March meeting, the odds are roughly 70%, more than double the end of last week.

Traders have also pulled forward the timing of the two rate hikes that they are fully pricing in for 2017, with the first occurring around May 2017 and the second in September 2017. At the beginning of the week, they were still anticipating June 2017 and December 2017.

Economic data offers support to Fed hike

Recent economic data have also supported bets on a March 2017 rate hike. The Fed’s preferred measure of inflation jumped 1.9% in January 2017 from a year earlier, approaching the central bank’s 2% target rate. Fed Chair Janet Yellen and Vice Chair Stanley Fischer are scheduled to speak on Friday, March 03rd, 2017, which is likely to fuel expectations of a rate hike.

The US economy clocked a seasonally adjusted annual growth rate of 1.9% in Q4 FY16, versus forecasts for a 2.2% growth rate, according to advance estimates released by the Bureau of Economic Analysis (BEA). President Donald Trump, in his speech on February 28th, 2017, was short on specifics about his already proposed $1 trillion stimulus package, tax cuts and regulation rollbacks, all of which would likely spur US inflation in the near-term.

Encouragingly, policy makers see GDP growing 2.1% in 2017, up from a previous forecast of 2%, while slightly reducing their outlook for unemployment to 4.5%. At its meeting on January 31st and February 01st, 2017, the Fed left interest rates unchanged. The focus now shifts to the Fed’s next meeting on March 14th-15th, 2017, where officials will assess the economic scenario before taking the decision to hikes rates if needed.

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