A rate hike today could send a damning message about the bond market

Maybe the bond market isn’t quite ready.

On Tuesday, the yield on the 2-year Treasury note jumped to a four-year high.

Short-term Treasury notes and bills are most sensitive to expectations for higher interest rates. And so the spike showed that bond traders are prepared for higher interest rates.

On Thursday morning ahead of the FOMC announcement, the yield on 2-year notes was at 0.81%, about 70 basis points above the federal funds rate, the Fed’s benchmark lending rate.

The wider that gap before a Fed decision, the more prepared for higher rates the bond market is.

In a note to clients on Tuesday, Societe Generale’s Kit Juckes noted that although the current gap shows a readiness for higher rates, this gap is historically low. Which could be fine. But this might also be a disaster.

Here’s Juckes (emphasis added):

When the Fed hiked rates from 1% to 1.25% in June 2004, 2-year notes were trading 180 bps above the Funds target. That’s a much bigger gap than was the case in 1994 (110bp), 1997 (99bp) or 1999 (93bp) and helps explain why the reaction to the move was a fall in yields and a fall in the dollar, though the S&P also fell. The gap today is a mere 70bp. If the Fed does raise rates today that tight 2yr-fed Funds gap reflects one of two things — either it’s a victory for forward guidance and we will see the market remain confident that the future pace of rate increases will be very slow, or it reflects complacency. The risk of the latter makes us nervous.

Earlier this week, we highlighted comment from one-time Fed chair frontrunner Larry Summers saying that the last time the Fed shocked markets, in 1994, it didn’t go down well and we ended up with the so-called “Bond Market Massacre,” when bond prices fell and yields went through the roof.

And so in Juckes’ view, either we’re set up for a similar event, or the Fed’s forward guidance worked like a charm.

Here’s what the gap between the 2-year yield and fed fund futures has historically been ahead of rate hikes:

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