With the deposit flights having happened over the past couple weeks, we anticipate that banks will continue to tighten lending standards and loans made to the corporate sector may contract further. The risks of a recession, credit distress, and financial instability have been increasing and may eventually, in a not too distant future, to tip the balance of the Fed’s policy decision into a pause or even cutting rates.
Short-term Treasury notes tend to do well in this environment
As the Fed is about to pause, Treasury yields tend to fall. The short-term Treasury yields are more directly a compounding of the expected Fed Fund rates in the coming months or coming one or two years. The yields on the longer-dated Treasuries, however, will tend to be driven by the expected path of trend economic growth, long-term inflation rate, and interest rate volatilities. Historically, when the Fed eases, short-term yields tend to fall faster and more than longer-term yields (Figure 3).
Before a recession, the yield curve is often inverted to reflect that the monetary policy is too restrictive and is about to trigger a slowdown in economic activities and inflation, leading to subsequent rate cuts. When approaching a recession, the market start pricing in the upcoming rate cuts and causes yields to fall but more so in short-term yields as the longer-term yields start to price in a recovery some years later. As a result, the yield curve steepens (Figure 3).