Short -Term Treasury Prices Say Investors Are Pretty Spooked

Even though interbank rates have come down, in all likelihood due to the operation of the Fed’s Term Auction Facility, Treasury prices indicate that investors are still worried about credit and counterparty risk. This may in part be a reaction to the losses suffered by enhanced cash funds and money market funds (although the latter and some of the former have been absorbed by fund sponsors).

From Bloomberg:

It was the worst housing market decline since the end of World War II. The Federal Reserve was doing everything it could do to avoid a precipitous recession and investors in the shortest-term U.S. government securities had reason to be jubilant.

While two-year Treasury notes returned 10 percent in 1989 as the target rate for overnight loans between banks fell four times, no one is saying deja vu this year. Even the bond market’s best start since 2001 won’t get investors more than 2 percent, according to a Bloomberg survey of 65 economists and strategists.

Anyone seeking safety from the slowing economy and securities tied to subprime mortgages helped drive yields on two-year notes 1.50 percentage points below the Fed’s 4.25 percent target rate last week. FAF Advisors, Federated Investors Inc., Fifth Third Asset Management Inc., Hartford Investment Management Co. and Pacific Investment Management Co., which together oversee $1 trillion, say the gap is too wide to justify buying the securities even if the Fed lowers rates as forecast.

Investors have “priced in a dire situation,” said Wan- Chong Kung, who manages $36 billion at FAF Advisors in Minneapolis, a unit of U.S. Bancorp. “We certainly have to be looking at a pretty tough economic environment with no near-term prospects for a return to economic growth.”….

Kung said commercial mortgage- and other asset-backed securities with the highest credit ratings offer better value than two-year notes because they were tarred along with subprime bonds. She’s also buying five-year Treasuries, which are less sensitive to changes in expectations for monetary policy….

The last time Fed rates were so much higher than two-year notes was in July 1989, when the gap reached 1.66 percentage points, the data show. The spread was greater than 1 percentage point twice since then. Once was in September and October 1998 following the collapse of hedge fund Long-Term Capital Management LP. The other started in November 2000 when policy makers were on the way to cutting the target rate to 1 percent….

Fed rates were 165 basis points above the yield on two-year notes Dec. 3, the widest since 1989, Bloomberg data show…..

“All the gains have been achieved already,” said Christopher Sullivan, who oversees $1.3 billion as chief investment officer in New York at the United Nations Federal Credit Union. “Bonds have run their course for this cycle unless we get extraordinarily weaker data,” he said after the jobs report.

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