Inside Markets — Two-year Yields

The front end of the yield curve may now be responding to the hot January/February inflation prints. Two-year yields reached resistance levels near 4.70% immediately after the January CPI/PPI reports, pulled back to bullish inflection levels near 4.50% and are now flirting with the 4.70% level again. The decline in 2-year yields from 5.20% in late October to ~4.80% in mid-November was aligned with an emerging theme of softening inflation, resilient growth and expectations for maybe 3 Fed rate cuts beginning in ~June ‘24. The late-November break below ~4.80% was the market’s confirmation of that theme and the mid-December break below ~4.50% reflected a bullish shift to more imminent easing beginning in March and a sequence of cuts thereafter. Now crossing above ~4.50% signals the repricing of Fed rate cut expectations back to 3 in total beginning in June. A break above ~4.80% would cause markets to question if the Fed will be easing at all in ’24 and maybe question the potential for additional hikes. The risk of rate hikes would also be reflected in the shape of the yield curve, specifically the 5/30 segment, which is now +15bp. A spread below +10bp would be a worrisome development with bearish implications for equity markets – potentially.

Two-year yields greater than 4.8% would reflect a higher-for-longer rate cycle and could restart concerns that something breaks in the economy. But 2-year yields >4.80% may also reflect the beginning of a global manufacturing cycle. Cyclical cross markets like the copper/gold ratio and Russell 2000 (RTY) trade mostly inline with where they should given that global manufacturing PMI sits at 50.3. Other cyclical markets like the Philadelphia Semiconductor Index (SOX), Italian BTP spreads, Mexican Peso and European equities – specifically autos – are suggesting a more bullish global growth forecast aligned with PMI trading well above ~52. We’ve spent a lot of time on the RTY and the significance of an upside break above its multi-quarter range at ~2100. We remain skeptical that the RTY can sustain levels north of ~2100, but a breakout would be a reason to suspend our disbelief about the emergence of a new global manufacturing cycle. If the RTY can sustain levels >2100 and global manufacturing PMI inflects higher in the months ahead, the RTY should vastly outperform SPX over the next 12-18 months.