Interest rates stopped going up last year but that doesn’t mean that they’ve started to go down. The yield on short term Treasuries, those maturing in two years or less, suggests the market expects interest rates to stay high for the foreseeable future. We’ll look at the curve and also expected volatility to see what the market currently expects.
Short term rates remain high
Short term treasury rates are the most sensitive to changes in the Federal Funds Rate (set by the Federal Reserve). In general, the treasury curve will lead changes in the Federal Funds Rate (FFR), i.e. if the market expects the Fed to cut the FFR, short term Treasury yields will move lower. You can see this relationship by looking at the market yield on a 1-year Treasury bill (blue line) with the FFR (red line):
Notice that in early 2022, there was a wide gap between the 1-year yield and the FFR. This was because the market expected the Fed to keep raising rates. So even after the FFR was raised to 0.50-1.0% in early 2022, the market expected that was just the first of many rate increases. As the FFR went over 4%, the spread between the 1-year Treasury yield and FFR narrowed (blue line and red line got closer). This was the markets way of expressing an expectation that the Fed would soon be done raising rates.
General rule: when the 1 year yield is much higher than FFR, the market expects the Fed to raise rates. When the 1 year yield is much lower than FFR, the market expects the Fed to lower rates. When the two yields are similar, the market expects the Fed to leave rates unchanged.
In late 2023/early 2024, the market started to believe the Fed would be lowering rates (so we saw the 1 year yield start moving below the FFR). Today, the spread has narrowed once again. Therefore, at this moment, we would classify the market as generally neutral on Fed policy over the next year; the market largely expects the Fed to keep rates around 5% over the next 12 months. This would imply a current market expectation for one or two interest rate cuts by the Fed between now and March 2025.
Markets seem comfortable with this expectation
The market seems comfortable with its current interest rate outlook. One of the ways we can judge the market’s comfort level is by looking at a volatility index tied to the interest rate market. The MOVE Index aims to reflect the collective expectations of market participants about future volatility.
If the MOVE index is high, then investors expect a lot of volatility in interest rates. This would be construed as the market being uncertain as to the outlook for interest rates. If the MOVE index is low, investors expect low volatility in interest rates. Low volatility is associated with a low surprise interval… i.e. the market doesn’t expect to be “caught of guard.”
Currently, the MOVE Index is near its lowest levels since the Fed began hiking interest rates in 2022:
The two big volatility spikes, when the interest rate market became highly uncertain of the outlook, was last March and October. That was when three large regional banks failed (March 2023), and the 10 year Treasury yield went above 5% for the first time since 2007.
Today’s current level in the MOVE Index is a confirming signal that the market, at least at this moment, doesn’t expect much movement in interest rates over the short-term.
2026-2030 look lower
For those wondering when the market starts to see meaningfully lower interest rates, you have to look out to 2026. The graph below plots the “yield curve” — the current yield of different maturities:
Here you can see the 2, 3, and 5 year Treasuries currently yield 4.80%, 4.50%, and 4.35%, respectively. These current yields are higher than they were at the end of last year when they were 4.25%, 4%, and 3.85%.
The fact these yields have moved higher over the last few months is another confirming factor that the market has adjusted to an expectation that interest rates will be “higher for longer.” You can use this website to see the yield curve at various dates, which is helpful in identifying changing market expectations.
In summary, interest rates appeared to peak last October when the 10 year treasury yield was yielding 5%. However, the top in interest rates has not yet been followed by a meaningful decline in interest rates. In fact, as 2024 has progressed, the market has settled into an expectation that interest rates may stay where they are at. This is important as it suggests rates on key loans, like mortgage rates, may be destined to stay around 7% for the bulk of the year.
For now, the market doesn’t see the start of a decline in interest rates until 2025-2026. The “new normal” of high interest rates looks a lot like the “old normal” of the 1990-2010’s, when interest rates spent most of their time in the 4-5% range. As always, this outlook can change, but for now that is where we stand.
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