Yield Curve Focus

A change in the tone of Federal Reserve rhetoric caused yields on short-term Treasuries to plunge while equity prices rose smartly. First, Chairman Bernanke pointed to the significant challenges that remain for the economy, while St. Louis President James Bullard hinted that rates could be on hold longer than markets have assumed. Bullard went further over the weekend, arguing that the Fed should extend its purchases of mortgage-backed securities and agency bonds beyond the planned termination in March.

 

The spread between two- and 10-year Treasuries steepened to 265 basis points, two standard deviations above its trend since September. The yield on the three-month T-bill fell to 0.05% for the week ending November 20, down from 0.11% in September. Rates on a select number of bills due to mature in January 2010 fell below zero, indicating investors were willing to pay a slight penalty for the safety of owning risk-free U.S. government securities. Yet investors were not acting out of fear of a market meltdown. The move instead stems from expectations that further credit easing may be necessary before the economy can sustain a recovery.

While some current interest rate movements undoubtedly have to do with year-end funding issues and banks' efforts to improve their balance sheets, the dovish turn in Fed rhetoric and nervousness about the durability of the recent equity rally pushed up prices at the short end of the curve. The Fed's slight change in tone caused investors to overlook better than expected economic data and pull capital from riskier assets, pushing down yields on government bonds and money market funds.

Thus, the contradiction that has characterized financial markets since September lives on: Lower yields, higher bond prices, and rising equity prices, all in the context of a weak dollar. For now, yields, equity prices and the greenback will remain acutely sensitive to changing expectations about how long the Fed will support financial markets. Consensus reports felt for some time the Fed's March 31 target for ending its asset purchases would be undone by a weak labor market, fragile housing, and diminished business access to credit. The central bank will extend and probably expand its MBS and agency debt purchases. The Fed will continue to foster a steeper yield curve that allows banks to recapitalize and cushion themselves against a sudden reversal in equity prices, which is an ongoing concern at the central bank.