What’s Next for Rates? | Bianco Research

Comment

Yesterday Jim was on CNBC discussing interest rates and the yield curve. He noted the 2-year note always peaks above the terminal rate (the rate where the Fed stops hiking). We detailed this in October.

Where Do Short Rates Peak?

The chart below shows the divergence between what the Fed is communicating (blue) and what the market is pricing in (orange). The Fed is saying the terminal rate will be 5.00% – 5.25%. The market thinks it is closer to 4.86%.

If the Fed is right and they are going to a 5.00% – 5.25% terminal rate, what does that mean for market-based interest rates such as the 2-year note?

The orange line below shows the target funds rate. The blue line shows the 2-year yield.

As the table shows, the last five rate hike cycles ended with the 2-year yield above the terminal fed funds rate. So, if the Fed’s projection of a 5% funds rate is correct, then history suggests the 2-year yield should be higher than this terminal rate, or at least 5.25%.

What Does This Mean for Long Rates?

Should the 2-year yield (orange below) keep climbing above 5.25%, we believe it will drag the 10-year yield higher (green). The yield curve (blue bottom panel), already at a 41-year extreme inversion, should not go much beyond -100 basis points, if it even gets that extreme.

So we look for long and short rates shift higher in parallel as the Fed continues to hike to their 5.00% – 5.25% terminal rate. If one is looking for a target, 2-year yields should reach 5.50% and 10-year yields should hit 4.50% by spring.

The Economy Is Not Breaking

The yield curve will stay range-bound precisely because the economy is not breaking, despite Wall Street’s near insistence that it will/should.

Consider the following chart of weekly initial unemployment claims. They are still not showing any sign of a weakening labor market.

And without a weakening labor market, falling wage inflation is not materializing. As the bottom panel of the following chart shows, average hourly earnings are holding around 5%.

If everyone is getting 5% wage hikes, they can handle 5% inflation.

Conclusion

We believe rates have not peaked and will not peak until we see evidence of weakening wage growth. Until then, rates across the curve will shift higher in tandem as the Fed continues to hike rates into 2023.