USD Rates: Factors at play in the front of the curve
The front of the USD curve continues to be buffeted by debt ceiling worries. The point of peak stress is set at 1 June where the 1M T bill is yielding close to 7%. Slightly further out, T bill rates are much closer to 5%. It probably does not help that Fitch has put the US on negative watch. Beyond the debt ceiling issue, the market is getting increasingly convinced that the Fed may have to deliver a hike in July (74% odds) after skipping June. Fed minutes released last night indicate a split on whether further interest rate increases are needed. At this stage in the cycle, policy flexibility will be key. Assuming that the debt ceiling gets lifted soon (limiting damage to the real economy) and no imminent banking sector stresses, it is reasonable that markets price in the risk of another move in the immediate few months.
However, conviction will be low given how fast the outlook can shift. To put things into perspective, the market was pricing in meaningful odds of a June cut and an end-24 Fed funds rate of 2.7% just over two weeks ago. Now, another hike is deemed more likely, while cuts out to 2024 got aggressively pared. The implied Fed funds rate for end-2024 now stands at 3.38%, up almost 70bps in a short span. At the most hawkish point in early March, the market was looking at a rate in excess of 4%. Noting that bearish momentum on UST is still there and factoring in another 50bps or so of adjustment higher in the implied Fed funds rate for end-2024, puts a soft cap of around 4.5% for 2Y yields. Meanwhile, we will be watching financial conditions closely. The levels of stresses thus far do not seem sufficient to warrant concern just yet but things could change quickly if yields take another surge higher. We would also be monitoring the 2Y/10Y spread to get a sense of recession worries and banking system stress. Deeper inversion of the 2Y/10Y towards -80bps (from -64bps now) would be a warning signal for us.
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