Fixed Income Recap

Treasuries rallied today after a number of issues plagued the market on Wednesday. The two-year finished up 1/32, and the ten-year was higher by a point. The benchmark curve flattened by 10 basis points, and currently sits at +265 bps. A basis point represents .01%.

The Treasury auctioned $26 billion in seven-year notes at a yield of 3.3%,

The Federal Reserve, who still denies having a specific target for certain interest rates such as residential mortgages, is definitely being forced to make a decision with rates moving higher. Thirty-year mortgage rates have dropped from 5.98% in November 2008, before the Fed announced the initial $500 billion in agency MBS purchases, to its current level of 4.81%. These record low levels are likely to rise due to the recent run-up in Treasury yields, but if we begin to see mortgage rates creep in to the 5%-5.15% area will that force the Fed to take action? If yes, then how?

The Fed’s MBS purchase commitments currently stand at 150% of 2009 supply and 25% of the market as a whole, how much more can they really buy? The Fed runs the serious risk of just inflating the recession away, through huge amounts of quantitative easing, only to have to trounce the next economic rebound to avoid hyperinflation. TALF has already been expanded to the point where the Fed is beginning to take some really questionable assets, on to their balance sheet, (subprime credit card loans and commercial real estate for example). When the Fed becomes such a major market participant, risk can’t be accurately measured by the private sector. Also not favorable for the long term.

Monetary policy, including quantitative easing, has a lagging effect. There is no doubt that the Fed has created a simulative rate environment, so the best course of action in my view would be to give it a chance to work. Even if it means no more 4.75% mortgages.

Have a great evening.

Cliff J. Reynolds Jr., Junior Analyst