2s5s Suggest Fed Tightening Narrative Fading Fast

Markets are increasingly pricing out the potential for a sustained Fed rate hike cycle.

• In retrospect, the clues for this could be seen initially in forward rates, which following the hawkish mid-June FOMC meeting priced in a slightly earlier beginning to Fed rate liftoff (end-2022) than it had in Q1 (early 2023), but also a slower path of hikes and a lower end-rate (e.g. 1.50% vs 1.75% by mid-2025).
• In other words, the rates market saw that earlier Fed liftoff meant it would not have as much room to hike. The Delta COVID variant/econ slowdown - combined with more-aggressive-than-expected Fed SEP hike dots - is one potential fundamental narrative for this.
• The narrowing of the 2s5s Tsy spread is indicative of this shift (see chart). We've gone from a 80bp peak in early Apr to 47bp currently. ~32bp of that 33bp shift has come via a drop in the 5Y yield (peak just below 1.00% to 0.68%), with the 2Y yield within 1-2bp of where it was at the early Apr peak.
• From a purely technical standpoint, the 2Y yield has held support at 0.20%, but the 5Y has broken through 0.70% (which had held through March-Jul). So the path is clear to a further drop in 2s5s to the 37-39bp area (the pandemic uptrend / Jan and Feb resistance).
• Such a move would imply that an imminent Fed rate hike cycle is almost entirely priced out. Much further and the conversation would turn to Fed easing.

US 2s5s spread (bp)Source: BBG, MNI