Yesterday was one of the more interesting fixed income days in a long time. The bond market was offered all day. That was not the unusual part. What was strange was how the short end of the curve led the move lower (higher in yield).

Big deal you might be saying. The market simply priced in an increased chance of the Fed tightening tomorrow. Wait, not so fast. Although they monkey hammered the two year note yesterday, the Fed funds futures for October 2015 did not budge.

Therefore you cannot argue the big rise in the short end of the curve was the result of an increased probability of tightening at tomorrow’s meeting. If that was the case, then we should have seen a big move lower in the October 2015 Fed Fund futures. That contract did not move at all.

So why did the two year sell off so hard? Maybe it was playing catch up to the longer end?

Nope, the 10 year yield is still miles away from the previous highs. So even though the 2 year note yield broke out, the 10 year yield is lagging the move.

I have two theories for yesterday’s strange action. The first explanation is the emerging markets sell off is causing foreign Central Banks to pitch their US treasuries as they defend their currencies. These Central Banks typically own the short end of the curve, so they would be leaning hard on the front end of the curve. The two year note is often priced off of the future expected path of Fed funds rates, but there can be premiums or discounts to this fair value depending on market conditions. If foreign Central Banks are demanding liquidity in the short end of the curve, this could explain why the 2 year yield is exploding higher. If this were the reason for yesterday’s sell off, this would be a bad development for financial markets.

The other possibility is that the two year note sold off for good reasons. In fact, bonds might have been on offer precisely because the market perceived the chances of the Fed tightening tomorrow have decreased. Why has the global economy been stumbling so badly recently? There are lots of reasons, but there can be no denying a hawkish Federal Reserve is one of the main culprits. Remember a relatively tight Central Bank policy is bond friendly – it slows down the economy and reduces the chances of every fixed income’s nemesis, namely inflation. Therefore a shift in perception about the Fed’s intentions could cause a bond sell off. However if this were the case, you would expect the long end to sell off harder than the short end, steepening the curve.

Yet as the 2/10 yield curve shows, this was not the case. So although it is a possibility yesterday’s big sell off in the bond market resulted from an increased chance of the Fed taking a pass on tomorrow’s hike, you would not expect the 2 year note to lead the charge higher in yield.

I don’t have any answers about why the short end of the curve is getting hammered so badly, but you should definitely keep your eye on it.

Thanks for reading,

Kevin Muir

the MacroTourist