The yield on the 2-year Treasury note continued to decline last week and finished the week at a lower yield than at the start of 2009. The fact the 2-year Treasury yield is now lower on a year-to-date basis is startling considering the robust performance of riskier investments such as Corporate Bonds, High-Yield Bonds, Commodities, and even stocks. On the surface, a new low for the year on the 2-year note would indicate a budding flight-to-safety rally. However, there are several rational reasons for the drop in 2-year Treasury yields, none of which are related to heightened risk aversion among investors about a renewed economic downturn.
T-Bill Supply Reduction
The most dominant factor has been a notable reduction in T-bill supply. In mid-September the Treasury announced it was not going to re-issue $185 billion in maturing T-bills originally issued as part of the Supplementary Financing Program (SFP). The SFP was launched during the fourth quarter of 2008 to assist bond market liquidity during the height of the financial crisis. With bond market liquidity vastly improved and the Treasury Department looking to extend the average maturity of outstanding debt, the Treasury decided to let all but $15 billion of SFP T-bills simply mature. The result was a 10% reduction of the T-bill market as the last SFP T-bill matured in late October.
The drop in supply comes at the wrong time as we approach year-end funding needs. As year-end approaches, banks and other institutions prepare to tidy up balance sheets by purchasing T-bills and other high quality short-term investments. To avoid illiquid trading conditions over the holidays, this process often begins before Thanksgiving. The commercial paper market, essentially the corporate version of a T-bill, is substantially reduced as a result of de-leveraging and disappearance of special purpose financing vehicles (SPVs), thereby leaving a greater-than-usual emphasis on T-bills as the vehicle of choice. Demand to fund over year-end is already reflected in zero yields on all T-bills that mature in January. Additionally, money market assets have decreased, but at $3.3 trillion they represent a hefty source of steady buying power.
The Fed is Your Friend
A friendly Federal Reserve has also been a key driver of the 2-year yield. The Fed continues to emphasize the “extended period” language when referring to the Fed funds rate. Last week, Fed Chairman Ben Bernanke, speaking before the NY Economic Club, once again reiterated that the Fed funds rate would remain low for an “extended period”. His remarks made absolutely no reference to the removal of monetary stimulus or taking steps to more proactively reduce cash in the financial system.
Most Fed speakers have reiterated Bernanke’s message with cautious remarks about removing stimulus too soon. Recently, St. Louis Fed President Bullard suggested the Fed may wish to keep the option open on bond purchase programs beyond March 2010 and when asked about timing for the first rate increase, Chicago Fed President Evans remarked “into at least the middle of 2010,” and the fi rst increase might not come until “late 2010, perhaps later in terms of 2011.” Fed fund futures pricing, one of the better gauges of Fed rate expectations, indicate the first rate increase will come at the September FOMC meeting. Previously Fed fund futures indicated the first rate increase would occur at the June FOMC meeting.
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Where's the Two Year Rate?
The decline of the 2-year note yield to 0.73% still keeps it in a range we roughly consider fair value. The 2-year maintains a tight relationship with the target Fed funds rate. Typically, when the Fed is on hold, the 2-year yield has traded 0.50% to 1.00% above the Fed funds rate. With target Fed funds currently 0.0% to 0.25%, the current 2-year yield is roughly in line with historical ranges. It is not uncommon for the 2-year yield to be lower than the Fed funds rate when the market expects a rate reduction. Although there is clearly no room for a lower Fed funds rate, the 2-year yield could drop further if the market truly believed that the economy was weakening again or that other monetary stimulus was forthcoming.
Domestic banks and foreign central banks have also played roles in a lower 2-year Treasury yield. Weak loan demand has left domestic banks with excess money reserves. With cash yielding next to nothing, banks are investing in longer-term securities such as the 2-year note. Short-term securities are much less sensitive to interest rate changes and when the Fed emphasizes it is on hold for longer, the risk in holding such a position is reduced.
Foreign central banks have purchased 2-year Treasuries as part of a renewed effort in currency intervention. The decline in the US dollar to its lowest point of the year has prompted concern from foreign governments whose economies are dependent on exports to the U.S. Foreign governments, via their central banks, have recently attempted to prop up the dollar via the purchase of short-term Treasuries.
The decline in the 2-year Treasury note yield to levels witnessed during the peak of the financial crisis has certainly caught the attention of investors. The drop in the 2-year yield has been particularly notable given the strong performance of riskier investments in 2009. However, several factors including a decline in T-bill supply, the Fed reiterating its “extended period” message, excess bank reserves, and foreign buying, have worked together to push the 2-year to its lowest levels of the past 12 months. These factors, and not a renewed flight-to-safety buying on renewed economic worries, have been responsible for the drop in 2-year Treasury yields.
- This was prepared by LPL Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you,
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