Fixed Income Recap

FOMC Announces Rate Cut
The Federal Reserve announced a reduction in the Fed Funds Target Rate, the rate at which banks lend to each other overnight, to a target range of between zero and .25%. The market rate has been within this range since the beginning of December, so that part of the announcement was less impactful than the comments that followed.

The Fed announced today that, “The focus of the committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the Federal Reserves Balance sheet at a high level”. Translation, look for expansion of Agency debt and MBS buying by the Fed. The limits currently sit at $100 billion of debt and $500 billion of Agency MBS. Along with other programs aimed at fostering economic growth through lending.

As financial markets remain strained, the Fed is looking for ways to bring liquidity to the system. The Fed’s balance sheet has more than doubled, from about $900 billion to about $2.2 trillion, in the last 6 months, mostly due to the liquidity facilities implemented recently and relaxed standards on collateralized lending to institutions. Today’s announcement foreshadows a future of creative easing by the Fed as they have “thrown in the towel” with regard to the Fed Funds Target.

Treasuries Rally
Treasury yields dropped to record lows across the entire curve today after the Fed made its announcement. The 2-year traded as low as 62 basis points before ending the day at 64.5 basis points while the 10-year ended the day at its low of 2.25%. The shape of the curve remains relatively unchanged from the beginning of the month after the massive flattening that took place in the second half of November. The spread between the two- and ten- year currently sits at 163 basis points.

Mortgages were tighter to comparable Treasuries before the Fed’s announcement this afternoon, after which they rallied along with seemingly every other bond. Thirty-year Fannie 5.5% mortgage pools widened about 3 basis points to Treasuries on the day, while 30-year 5% pools ended the day about where they closed Monday. Investors continue to be worried about accelerating prepays, resulting from rumors of new, more lenient, refinancing programs, causing “up in coupon”, 5.5% compared to 5%, pools to underperform. If there is any truth to these rumors we would expect to see even further underperformance.

Cliff J. Reynolds Jr.
Junior Analyst