Rate Hike Coming?

Fed funds futures are pricing in a near certainty of a rate hike at next week’s FOMC meeting, although you wouldn’t know it by looking at the 10-year Treasury (NYSEARCA:IEF)yield, which has been sinking like a stone in recent weeks.


By James Picerno

The benchmark 10-year rate fell to 2.14% yesterday (June 6), a seven-month low, based on daily data via By contrast, the policy sensitive 2-year yield has remained relatively stable, inching down to 1.30%, but that’s close to an eight-year high.

The elevated 2-year rate aligns with a roughly 96% probability that the Fed will announce another increase in interest rates on June 14, based on expectations via futures data published by the CME Group (as of early trading on June 7). The only mystery: Why is the 10-year yield contesting this forecast?

One theory that’s resonating with traders is that the appetite for hedging has surged ahead of tomorrow’s UK elections and scheduled testimony of former FBI director James Comey’s testimony in the US Senate – two events that, in theory, could ramp up geopolitical risk by a hefty degree, depending on the results.

Political tensions in the Middle East have also increased this week in the wake of announcements by Saudi Arabia, Egypt and seven other countries in the Gulf region to sever ties with Qatar, the world’s biggest exporter of liquefied natural gas and a key US ally as a base of air operations in that corner of the world. CNN calls the news “the biggest political crisis to hit the Middle East in years.”

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One byproduct of the shifting alliances in the Gulf is a sharp increase in the price of gold, which is considered a safe haven in many parts of the world. The spot price of the precious metal surged to just below $1,300 an ounce on Tuesday, a seven-month high.

As for the slide in the 10-year yield, note that this decline has been accompanied by similar moves in long-dated Treasuries. Meantime, rates at the 2-year maturity and below are holding at or near recent highs. In other words, the Treasury yield curve continues to flatten.

The 10-year/2-year spread, for instance, dipped to just 84 basis points yesterday, the lowest since last September.

The question is whether the latest swoon in long yields is a temporary dip that will evaporate after tomorrow’s UK election and Comey testimony – assuming there are no political bombshells lurking. The Qatar issue isn’t going to be resolved any time soon, but perhaps the crowd will become immune to the shifting alliances and view it as one more risk factor to deal with in the already tortured realm of Middle East geopolitical crises.

In other words, it’s reasonable to assume that the 10-year rate’s decline isn’t directly related to deterioration in the US economy, which is widely expected to remain on a moderate course of growth for the near term. Second-quarter GDP, for instance, appears on track to post a solid rebound after Q1’s sluggish rise.

What if the 10-year rate continues to slide? The reaction will depend on the incoming economic news. For now, investors are inclined to view the drop in long rates as an anomaly. The bigger question is whether the Fed agrees? The answer awaits in next week’s policy announcement.