May 31, 2016

Overall in the past month the 10-year treasury rate ended nearly where it began, but with come significant ups and downs along the way. On the short end of the curve, however, we have seen the 2-year treasury increase by 15 basis points from the beginning of the month. Overall the market seems to be preparing itself for a June rate increase by the Fed, even though the implied odds of an increase, based on futures prices, remain at 35%. This is a very large increase from a less than 10% chance just over one month ago.

In the meeting minutes from the Fed’s April meeting, the possibility of a rate increase in June was considered likely, so long as there continued to be improving economic data to support that decision. That being said, employment data for April was a bit underwhelming, but the bigger number will be the May employment report on this Friday. This will be the final employment report prior to the Fed’s June meeting, and could very well be a large piece of the Fed’s rate decision. Inflation has also finally moved closer to the Fed’s target in the last two months, giving a little bit more ammunition to the Fed if they do decide to increase rates.

The Fed’s two-day meeting concludes on Wednesday, June 15, at which point we will know if the federal funds rate is going to increase from 50 basis points to 75 basis points. My opinion is that the actual chances of a rate increase are greater than the 35% implied odds, and that it is likely closer to 50%.

Equity prices have also trended higher in the last month, with the S&P 500 now up 2.4% on the year. Considering that the first quarter of 2016 was all but lost to a rapidly declining stock market and subsequent recovery, the second quarter has posted gains of nearly 2% by itself.

If the Fed does decide to raise rates at the June meeting, expect to see the short end of the yield curve increase slightly. Rates have already moved higher in anticipation, thus if the Fed does not increase rates, I would expect to see treasury prices climb higher after the June meeting. On the longer end of the curve, I would not expect much movement in the 10-year as the curve continues to flatten out. In fact, it is entirely possible that the back end of the curve could remain constant while only the front end moves.

On a very short term basis, the 10-year treasury has developed a trading range from 1.81% to 1.89%. Looking from a slightly longer perspective, the wider range continues to be between 1.70% and 2.00%. We have been below the 2.00% level since January, and likely need an external factor such as the Fed to push us back to those yields.

Eric Swanson, CFA