Fed's Dot Plot: A Ticking Time Bomb for Treasuries?

The Fed's Dot Plot and Treasury Yields

The Federal Reserve's upcoming dot plot release is poised to send shockwaves through the Treasury market. The dot plot, which previously indicated three interest rate cuts for 2024, is under intense scrutiny. If the Fed withdraws the possibility of these cuts, Treasury yields could surge past 5%.

• Two-Year Yields: If the Fed's dot plot eliminates the three projected cuts, two-year yields are expected to climb to 5.12%. This projection is based on the historical response of Treasuries to shifts in Fed rate pricing.
• Current Market Pricing: The Treasury curve is currently priced for nearly two cuts. Any deviation from this expectation, such as the Fed indicating just one cut, will still push both two- and 10-year yields higher.
• Fed's Historical Projections: In December, the Fed penciled in three rate reductions and maintained this stance in March. A pivot to fewer cuts would acknowledge persistent inflation and a robust economy, providing the Fed with flexibility should the job market weaken.

Economic Projections and Market Reactions

Traders will be closely analyzing the Fed's summary of economic projections, particularly the core PCE and jobless rate estimates. These projections will offer insights into the Fed's inflation outlook and labor market expectations.

• Core PCE: The Fed's December estimate for core PCE was 2.4%, revised to 2.6% in March. With the measure averaging 2.8% this year, an upward revision would merely reflect current realities.
• Jobless Rate: The Fed may leave its jobless rate estimate at 4%, with the average so far this year at 3.9%.
• Long-Run Funds Rate: In March, the Fed projected a long-run funds rate of 2.60%, up from the traditional 2.50%. Given robust job creation and factors driving demand for funds, the neutral rate may have shifted higher. However, it's unlikely the Fed will continue raising this estimate at successive meetings.

Market Sentiment and Volatility

Despite the looming risks, some traders are adopting a bullish stance on Treasuries. The positioning in options markets suggests a glass half-full view, with bullish options on Treasuries with maturities over 20 years outnumbering bearish ones by 1.6 times.

• Volatility Expectations: Intraday volatility is expected to be elevated on Wednesday, coinciding with the release of May's headline inflation data and Chair Jerome Powell's press conference. The average range for realized volatility on a Fed day this year has been 12 basis points for two-year Treasuries and 11 basis points for 10-year maturities.
• Bullish Positioning: The higher ratio of bullish options may indicate that traders see an asymmetric risk-reward equation, with elevated yields offering attractive returns for those willing to chase duration this late in the cycle.

A Thought

The Fed's dot plot is more than just a set of projections; it's a barometer for market sentiment and economic expectations. As we approach the release, the market's reaction will hinge on the Fed's ability to balance its inflation outlook with economic growth. The stakes are high, and the potential for volatility is significant, making this a critical juncture for Treasury investors.