The shift in short-term interest rate markets Monday was unlike almost anything seen for more than four decades, including even the 2008 financial crisis and the aftermath of the Sept. 11 terror attacks.
The one-day drop in two-year yields was the biggest since the Volcker era in the early 1980s and surpassed the period surrounding the Black Monday stock-market crash of 1987. At one stage they plummeted as much as 65 basis points to 3.935%, before moving to be down around 61 basis points. The moves came as traders radically rethought their expectations for Federal Reserve monetary policy in the wake of several bank failures and the rollout of a new government backstop facility.
Monday marked the third-straight day of massive yield declines in the two-year note, bringing the total over that period to more than a full percentage point. Demand for Treasuries of all maturities surged as investors continued to flee US bank shares even after US regulators announced a rescue plan Sunday evening.
Swap contracts referencing Fed policy meetings — which last week favored a half-point rate increase at next week’s gathering of officials — slashed the odds of any increase from the current range of 4.5%-4.75%. The prospect of a boost at the March meeting are now less than one-in-two and the market is now suggesting the peak for this cycle will be, at most, a quarter-point higher than where it is now. Meanwhile, contracts for the rest of 2023 suggest that the Fed could cut rates by almost a full percentage point from the peak in May before the year is out.
“Today’s trade is owning the front end as financial conditions are tightening with a bad outlook for risk assets,” said Priya Misra, global head of rates strategy at TD Securities. “The Fed wanted to tighten financial conditions but not in a disorderly way, so some rate hikes being priced out makes sense.”
Rate cuts, on the other hand, are difficult to envision as inflation remains elevated, Misra said. Key inflation data for February — the consumer price index — are slated to be released Tuesday.
The repricing in rate-hike expectations reflects the view that financial stability risks will matter more to the Fed next week than inflation rates that remain well above its 2% target despite eight consecutive increases in the target band for the federal funds rate over the past year.
Economists at Goldman Sachs Group and Barclays scrapped calls for a rate hike at next week’s meeting, with NatWest Group also predicting the Fed will resume reinvesting its maturing holdings of Treasury and agency debt. Nomura went a step further, calling for a rate cut in March and and end to Fed quantitative tightening.
“A lot has changed over the weekend,” said Daniel Ivascyn, chief investment officer at Pacific Investment Management Co. “There has been a meaningful tightening of financial conditions and significant risk aversion that we don’t think is over. This is likely a multi-month adjustment process” for the financial system.
Last week’s collapse of Silicon Valley Bank, the first U.S. bank failure since 2008, highlighted the fallout from higher interest rates, which spurred a dramatic tightening in financial conditions. Two other lenders, Silvergate Capital Corp. and Signature Bank, also closed.
“Every time we see stuff like this, the Treasury market is the haven,” said Jack McIntyre, portfolio manager at Brandywine Global Investment Management. “It’s amazing if you are positioned correctly and very frustrating if you are not.”
Yields pared their declines somewhat beginning shortly before midday in New York. At that time, two Treasury bill auctions drew much higher than expected interest rates, a sign that the rally deterred some investors. Simultaneously, a report that the US system of Federal Home Loan Banks was raising funds through a short-term note offering appeared to curb demand for Treasuries.
Trading volumes were heavy. Strategists at BMO Capital Markets estimated activity in Treasuries was about 300% of the 10-day moving average.
Less than a week ago the two-year note’s yield reached a multiyear high of 5.08% after Fed Chair Jerome Powell in congressional testimony said the central bank was prepared to reaccelerate the pace of rate increases if warranted by economic data. Longer-dated yields declined less, lessening the inversion of the Treasury yield curve. The 10-year Treasury yield shed about 13 basis points to 3.57%, narrowing its gap with the two-year from more than a percentage point just last week to about 40 basis points.
U.S. regulators on Sunday set up a new emergency facility to let banks pledge a range of high-quality assets for cash over a term of one year, and pledged to fully protect even uninsured depositors at the lender. SVB’s descent into FDIC receivership — the second-largest US bank failure in history behind Washington Mutual in 2008 — came suddenly on Friday, after a couple of days where its long-established customer base of tech startups yanked deposits.
Still, concerns are growing that the failure of the three banks may just be the tip of the iceberg.
The Bank Term Funding Program “prevents fire sales of Treasuries and mortgage backed securities and helps with the liquidity issues,” said TD’s Misra, adding that the support “doesn’t solve capital issues, so it hurts risk assets and Treasuries are a hedge against that.”