The two-year Treasury yield may sound like a bit of a financial arcane, but its recent decline signals something important for the stock market. The Federal Reserve may be close to completing its rate hikes.
The two-year yield has fallen to just under 4% from a decade-long high of just over 5% hit on March 8. That’s well above the sub-0.2% level recorded at the pandemic-era lows, but the new movement is still noticeable.
The drop comes as recent problems in the banking sector threaten the economy and raise the possibility that the Fed will not hike rates as aggressively as it has done so far. The risk is that banks facing deposit losses will either pay more and erode their profits, or let the money fizzle out, affecting their ability to lend if not their ability to continue operating.
Both scenarios would reduce demand for goods and services and weaken the economy, forcing the Fed to stop raising interest rates. Bank failures in addition to those of Silicon Valley Bank and Signature Bank would make the situation worse.
Investors already appear to be expecting the Fed to take a less aggressive stance at its March 21-22 meeting. The fed funds futures market suggests the bank will most likely hike rates by a quarter of a point, consistent with the move it made in February, rather than a half-point hike as it did in December has.
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In response, the two-year yield, which accurately reflects future expectations for the Fed Funds rate, has now fallen to a key level. It briefly fell below its 200-day moving average of 3.92%, according to Evercore data, and was just above it on Friday, according to Dow Jones Market Data.
The 200-day moving average has been rising over time, suggesting that investors were generally anticipating tighter policies, so a decisive move lower would signal a change in their views. If the yield holds steady at the 200-day moving average, it would indicate a greater chance that the Fed could remain in rate-hiking mode.
All of this has major implications for the stock market. An end to tariff hikes intended to dampen demand for goods and services would be positive for prices.
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For over a year, the stock market has risen when yields fall and stocks have fallen when yields rise. And stocks are already reacting to the decline in the two-year yield.
The S&P 500 has held above the 3800 level for the past week, a level where buyers have jumped in many times in recent months to support the index. It was just above 3900 as of Friday afternoon after a few days of declines in reaction to the banking news.
This floor for the index would fall below if interest rates fall too quickly. A quick decline would mean the bond market believes the economy is about to take an ugly turn that would require rate cuts. That would hurt stocks, which need to reflect the reality of falling sales and earnings forecasts.
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So just keep an eye on the two-year return.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com