Fixed Income Weekly

Rates rose significantly in a week dominated by poor Treasury auctions and public statements by Ben Bernanke and other Fed officials. The yield on the two-year finished the week 6 basis points higher at 1.05%, while the yield on the ten-year rose 16 basis points to yield 3.85%. The broad bond market was down .51% for the week. US credit followed stocks higher while MBS held steady ahead of next week’s end to the Fed’s mortgage purchases.

I have spoken a lot about yields being stuck in a range for the past 15 months or so, and much of the same is likely to persist until the market senses that the Fed is closer to the removal of emergency levels of liquidity. The graphs below show the current range for the 2-year and the 10-year.


The 2-year and 10-year are in two different places within their ranges. The ten-year sits at the top of its range while the 2-year is more in the middle. As a result we now have record levels of steepness and liquidity is still being heavily favored in the market as investors continue to guard against rising rates. Despite differing greatly now, 2 and 10 year yields are set to converge as the Fed begins to reverse monetary policy. This isn’t a revolutionary view. Short term rates stand to move higher when the Fed tightens, and long term rates may actually come down depending on how the market views the Fed’s stance on inflation. Right now, the Fed isn’t even considering inflation as an issue, which could prove troublesome if they aren’t able to recognize the effects of their policy soon enough. Inflation expectations according to breakeven yields on 10-year TIPS are holding steady at around 2.25%, essentially unchanged since the beginning of this year.

I’m not saying the current position of rates is unjustified. In my opinion it makes sense for rates to be where they are. Bernanke commented briefly this week on the meaning of the “extended period” language, stating that there is no set period of time to be assigned to those words. I didn’t expect to hear him say “extended period means 6 months”, but questions from house members forced him to talk more about the subject than he felt comfortable with I think.

Below is the excerpt from his prepared remarks detailing asset sales.

If necessary, as a means of applying monetary restraint, the Federal Reserve also has the option of redeeming or selling securities. The redemption or sale of securities would have the effect of reducing the size of the Federal Reserve's balance sheet as well as further reducing the quantity of reserves in the banking system. Restoring the size and composition of the balance sheet to a more normal configuration is a longer-term objective of our policies. In any case, the sequencing of steps and the combination of tools that the Federal Reserve uses as it exits from its currently very accommodative policy stance will depend on economic and financial developments and on our best judgments about how to meet the Federal Reserve's dual mandate of maximum employment and price stability.

In my mind his remarks telegraphed a removal of at least some of the longer-term securities on the Fed’s balance sheet (i.e. MBS, Treasuries and Agency debt), before an actual rate hike. He still maintained that reverse repurchase agreements, where the Fed would essentially lend out their securities for a predetermined amount of time, are still an option but talked more about actual sales more than he has ever before. In my eyes the MBS purchases were even more “emergency” than bringing the funds rate at zero, making it the logical choice to remove first. With that being said, there is no way to really know until they decide to move. Until then I will speculate.


Have a good weekend.

Cliff J. Reynolds Jr., Investment Analyst