Thoughts on ... The Terrible Twos

March 03, 2023 | Matt Barasch


Let’s start with a chart and then comment:

Here, we are looking at the yield on the 2-year U.S. treasury bond, which as you can see, made new cycle highs this past week. The 2-year is important for a variety of reasons, but perhaps the biggest reason is that it gives us a very good idea as to what investors think the Federal Reserve is going to do over the next 2-years in terms of monetary policy. How so, you might ask?

Basically, the 2-year bond is all about two things – averages and expectations. In terms of averages, the 2-year yield is essentially what shorter term bonds (1-month, 3-month, 6-month, etc.) will average over the next two years. Along the same lines, it’s also based on expectations, as we do not actually know what these shorter term bond yields will be over the next 2-years, so investors are collectively making predictions on what they will be.

A rising 2-year yield means that investors are expecting shorter term rates to average a higher value over the next 2-years, whereas a falling 2-year yield reflects the opposite. Federal Reserve policy has a massive impact on short-term rates, so it is, perhaps, the most relevant to where 2-year yields will go. With that in mind, let’s add to our chart:


Here, we are looking at the Fed Funds rate vs. the 2-year over the past year and a bit. As you can see, the Fed Funds rate ran below the 2-year until the end of 2022 when it briefly surpassed it (peaking at about a 30-basis point gap), while in the past couple of weeks, we have once again flipped the other way with 2-year yields higher than the current Fed Funds rate.

What does this mean? Well, when the Fed Funds is well below the 2-year, it means investors think the Fed is going to raise rates a lot in the near term in order for that 2-year forward average of Fed Funds rates to resemble whatever the yield is on the 2-year bond. So, as we look back at early to mid-2022, there is no surprise that the 2-year is well above the Fed Funds rate as by mid-year, we knew the Fed had a lot more work to do in raising rates.

However, as we got to the end of 2022, the expectations of future hikes began to drop and some expectation of future cuts began to get priced in. This part is a little bit tricky, but again, it’s all about averages and expectations. At the beginning of 2023, investors expected a couple of more Fed rate hikes in the first few months of 2023, but they also expected the Fed to begin cutting rates by late 2023/early 2024. So, when you took the expected average of these Fed Fund rates, you got a result very close to where the Fed Funds rate currently is – which is why the Fed Funds rate and the 2-year converged. Now, with the 2-year yield around 4.9% vs. a Fed Funds rate of around 4.6%, the market once again expects at least one net rate hike.

Okay, now why do we care? Well, with the recent break higher in the 2-year, the market now expects that the Fed is both likely to raise rates further than was thought before and for the Fed to potentially be slower to cut rates. In our view, this will continue to be a headwind for investors as we ultimately cannot properly asses the damage to the economy from rising rates until rates stop rising.

What about Canada? We have said for some time that we do not expect any further rate hikes from the Bank of Canada. However, let’s run a similar exercise to see where the market currently is priced:

As you can see, the market peaked at a minimum of nine expected rate hikes back in June of 2022, but by the start of 2023, the market was pricing in at least two cuts over the next two years. This has since dropped to one cut, largely because Canada continues to generate robust employment growth (150k in January).

Unlike the U.S., where two to three more quarter point hikes seem likely, we think the Bank of Canada will be content to sit tight. We base this on two things: 1) the inflation data in Canada continues to move in the right direction; and 2) the Canadian economy is much more sensitive to rate hikes given the amount of indebtedness at the consumer level and the shorter-term nature of most Canadian mortgages (most U.S. mortgages are done at 30-year fixed rates).