Two-year Treasury yield falls below 3.9% as market and Fed diverge

What’s happening

• The yield on the 2-year Treasury
  TMUBMUSD02Y,
  3.755%
  was 3.871%, down from 3.939% on Wednesday.

• The yield on the 10-year Treasury
  TMUBMUSD10Y,
  3.348%
  was little changed at 3.392% from 3.401% on Wednesday afternoon.

• The yield on the 30-year Treasury
  TMUBMUSD30Y,
  3.727%
  was also little changed at 3.715% versus 3.713% as of late Wednesday.

What’s driving markets

The 2-year Treasury yield was headed for its third straight decline in as many sessions as of Thursday morning, a sign that historically has signaled the view by traders that the Fed is making a policy mistake.

U.S. regional banks remain in focus as shares of PacWest Bancorp 
PACW,
-43.31%
tumbled on Thursday, taking other bank stocks with it. The prospects of further stress in the bank sector had fed funds traders pricing in a 100% likelihood that the Fed will cut interest rates by December, despite Chairman Jerome Powell’s comments on Wednesday to the contrary.

Read: Four things we learned from Powell’s press conference after latest Fed rate hike

As of Thursday morning, fed funds futures traders saw a small 6.6% chance that the first rate cut take place in June, while pricing in a 93.4% probability that the Fed will leave interest rates unchanged at between 5% to 5.25% next month, according to the CME FedWatch tool. The central bank is mostly expected to take its fed funds rate target back down to at least between 4.25% and 4.5% by December, according to 30-day Fed Funds futures.

In U.S. economic updates on Thursday, initial weekly jobless claims rose by 13,000 to 242,000 at the end of April, a sign of softening in the labor market. The U.S. trade deficit fell 9% to a four-month low of $64.2 billion in March on shrinking imports, while first-quarter productivity fell sharply at a 2.7% annual clip as the economy slowed.

The European Central Bank lifted interest rates by 25 basis points, slowing the pace of monetary tightening, and ECB President Christine Lagarde said that “we are not pausing, that’s very clear.” The German 10-year bund yield
TMBMKDE-10Y,
2.189%
rose 2.1 basis points to 2.273%.

What analysts are saying

• In the U.S., “it is clear they are getting closer to the end of their tightening cycle, but he [Powell] was non-committal on a pause,” said Larry Kochard, chief investment officer at Makena Capital Management. “It seems likely that there will be a pause, but the markets may not see the size of rate cuts that are priced in through year-end.”

• Citi “projects high inflation prints in the run-up to the June FOMC, and expects the Fed to hike rates at both the June and July FOMC — taking Fed fund rates to 5.5-5.75%,” said economist Johanna Chua and others in a note. “The market’s interpretation of the FOMC is different, especially with continuing concerns over U.S. regional banks. Market pricing suggests ~60% chance of a rate cut by the July FOMC and a cumulative 90 basis points of cuts by the end of this year.”