Stocks May Suffer As The 2-Year Rate Breaks Out

• 2-year Treasury surged above 4% following the FOMC meeting
• The 2-year may now be heading to around 4.5%
• This should result in great stock market volatility

The 2-year Treasury rate moved above 4% following the FOMC meeting on Sept. 21, and it may not be over. The FOMC meeting revealed many details and laid out a potential path for monetary policy for the rest of 2022 and 2023. The course was more hawkish than expected and paved the way for a 2-year rate that may soon breach the 4.5% level.

The rate is now just playing a game of catch-up to the December 2023 Fed Funds Futures contract. Since the beginning of August, it has been moving nearly lock step with the December contract, trading about 20 basis points lower.

2-Year Yield Vs. December Contract

If the market believes the FOMC Summary of Economic Projections and rates are heading to 4.6% on the overnight Federal Funds rate, then the December contracts will need to rise to that 4.6% level over time. Based on that current spread between the 2-year and those December contracts, the rate should also approach 4.4% to 4.5%.

Technical Breakout

The technical chart also would suggest that the 2-year could push even higher from its current levels around 4.15%. There is only one technical resistance level, around 4.25%, and no natural resistance until the 2-year gets to roughly 4.65%. This wide range of resistance is because of how quickly rates dropped in 2007 as the market began to price-in the rising risk of a recession.

2-Year Yield

Increasing Volatility

Rising rates at the front of the curve will be bad for stocks overall as credit spreads widen. A ratio of the iShares 1-3 Year Treasury Bond ETF (NASDAQ:SHY) and the iShares iBoxx High Yield Corp Bond ETF (NYSE:HYG) mimics the Markit CDX High yield spread. The ratio compared with the VIX shows that when this high yield spreads rise, the VIX rises, indicating that stock market volatility is picking up.

SHY, HYG Daily

Of course, higher volatility is not good for stocks in general or higher beta names. Unfortunately, these can be names that have already suffered mightily, such as many of the pandemic names that many investors fell in love with.

Many of these stocks are already down sharply, even if their valuations today make more sense than they did about a year ago. If the market does start to see a surge in volatility in the near term, these stocks will not be immune.

Over the next several weeks, it seems likely that the 2-year rate could still be heading much higher. As those rates continue to push higher, it is very likely to spill over into stocks in the form of increased levels of volatility and lower prices.

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