Several weeks ago, treasuries at the short end of the curve fell by around one percent within only a small handful of trading sessions. This meant that the valuations of US national debt due for maturity within a couple of years went up in value and much more violently than such instruments are accustomed to. The catalyst for the move higher in debt yields was a move away from risk sparked by the collapse, or forced sales, of more than one US bank. More than reflecting a higher demand for safe government debt, the pricing also signalled that the bond market believed that the Federal Reserve had no more room to raise rates in its inflation fighting mission. That is to say that market had believed that the raising of rates could have been a catalyst for the failure of such banks and the Fed would be forced to pause.
The move in the treasury yield curve at the time not only demonstrated the market’s belief of a constrained Fed but it also reflected and in turn cemented recession expectations. A fall of 1% on implied 2-year yields not only raised the probability of a recession but it was screaming that the US and likely global economy was already in one. However, a glance at other markets and in particular the closely related corporate credit market revealed a stark contrast. Other markets did not and continue to not demonstrate such disaster pricing, leaving the US treasury market largely on its own in pricing Armageddon. There remains the possibility that other markets were too sanguine and complacent in their price adjustments following the collapse of these US lenders. However, the far more likely conclusion, which still remains somewhat unconfirmed, is that the US Treasury market overreacted to events in the US banking sector.
This is not to say that what happened in the US was insignificant or that the risk of a financial crisis looming just around the corner is zero. It is merely to say that the collapse of some undercapitalised marginal lenders was not worth the multi-billion Dollar collapse in Treasuries that we observed. Looking at the recovery in fixed income pricing in recent sessions we find a reversal in some of the collapses in short term yields. For the May Fed meeting, we now observe around an 80% probability of a further hike, something that was believed to be unthinkable to observers of the fixed income market only a few weeks ago. The conclusion for the FX market is that the foregone conclusion of a weaker US Dollar could have a reality check if strong rate expectations are restored and sustained. Some lower yielding currencies will face increasing pressure to continue to commit to their own hiking cycle if domestic and international inflationary pressures continue to build.
Discussion and Analysis by Charles Porter
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