For months now, it seems like investors have been talking about – and hoping for – a so-called “Fed Pivot.” That’s when the U.S. Federal Reserve ends its rate-hiking campaign and starts supporting economic expansion (and rising stocks).
Thus far, hopes for a Fed policy pivot have proven to be little more than wishful thinking.
For the past 12 months, the central bank just kept hiking interest rates.
But the data finally suggests that the long overdue pivot is now imminent.
Seasoned investors know that short-term Treasury yields track Fed policy. That is, longer-term yields like the 10-year track a number of factors, including inflation and economic growth prospects. But shorter-term yields like the 2-year pretty much exclusively track the Fed Funds rate on a near 1-to-1 basis.
Every once in a while, though, this relationship breaks.
The 2-year Treasury yield starts to diverge from the Fed Funds rate. This happens when the bond market starts front-running a shift in Fed policy.
One such major divergence is happening right now.
Yield Spread Points to a Fed Policy Pivot
Over the past few weeks, the 2-year yield has collapsed amid mounting evidence that inflation is crashing and the economy is grinding to a halt. The Fed Funds rate, though, hasn’t budged. This has caused the 2-year to drop more than 100 basis points below the Fed Funds rate.
Historically, every time this has happened before, a Fed pivot was imminent.
That is, every single time the 2-year Treasury yield has dropped more than 100 basis points below the Fed Funds rate, the Fed went from hiking rates to cutting them.
For all the talk of rate hikes from various Federal Reserve members, the bond market is telling the Fed that it has no more room to hike. It’s time to cut.
The Fed will listen to the bond market. It always does, as the chart above shows. Every time the bond market tells the Fed this loudly that it needs to cut rates, the Fed ends up cutting.
The Final Word
The long overdue Fed policy pivot is imminent.
That’s important.
Every time the Fed pivots from hiking to not hiking rates – otherwise known as a “Fed pause” – stocks rally significantly.
Specifically, every single time the Fed has paused its rate-hike cycle over the past 40 years, stocks rallied over the next few months, with returns often running north of 20%.
This time will not prove different.
A Fed pivot is coming. So, too, is a big stock market rally.
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On the date of publication, Luke Lango did not have (either directly or indirectly) any positions in the securities mentioned in this article.
