2-Year T-Note Yield Calls For a Fed Cut

I have been writing since 2009 about how the 2-year T-Note yield gives a great message about what the FOMC should do with its Fed Funds target.  It is gratifying to see how so many other analysts have now picked up on this topic.  Unfortunately, the FOMC has yet to do so, and the members and their 400 PhDs working at the Fed seem to think that they know better than the bond market.

Exactly how the 2-year yield seems to know ahead of time what the FOMC is going to (eventually) do is an interesting question, but not an essential one.  There is a long enough track record of the Fed eventually doing what the 2-year says they should.  How long they wait to get around to that is a big variable, and the longer they wait the more problems they seem to cause.

2007 was perhaps the biggest example of this.  The real estate bubble had popped, and prices of homes and condos were already falling dramatically by the time the FOMC made its first rate cut on Sep. 18, 2007, dropping the Fed Funds target from 5.25% to 4.75%.  But by the time the FOMC did that, the 2-year T-Note yield was already down to 3.97% and falling fast.

The FOMC members pretty quickly came to realize that they had a big problem on their hands, and they made a 3/4 of a point rate cut on Jan. 22, 2008.  But even with that drastic cut, they were still behind the power curve since the 2-year yield then was already down to 2.00%.

The necessity for those dramatic cuts came about in part because the Fed kept rates too high in 2007, trying to make sure they had thoroughly popped the real estate bubble.  That put the brakes on too hard, and they had to scramble to clean up their mess.

We are thankfully not suffering the same problems now, but the Fed is risking a lot by thinking they know better once again.  As of July 25, the Fed Funds target rate of 4.375% is 0.44 percentage points too high, according to the 2-year yield.  So the FOMC at its July 30-31 meeting could make a quarter point cut, and they would still be "tight".

We have seen other times like early 2022 when the Fed was slow to hike rates, and had to scramble to catch up to where the 2-year yields had already gone.

Chairman Jerome Powell likes to assert that the FOMC is "data dependent" in terms of setting its interest rate policy.  That may be true, but they are depending on the wrong data.  They need to start inviting Professor Two to the Jackson Hole Conference, and listen more closely to its messages.