Market update _ 4 14 09

Treasury yields have been dropping like Somali pirates over the last two days. The Fed was in the market yesterday buying Treasury bonds in their continuing effort to keep rates low. Plan “A” is to purchase $300 billion in Treasury bonds to keep a lid on borrowing costs. The Fed purchased $7.37 billion of Treasury bonds yesterday. Today’s Open Market Operations will purchase Treasury bonds with 4 to 7 year maturities. There is no listed target amount that they are trying to purchase today. The Fed provides a list of cusips that they are interested in to the primary dealers, the dealers submit bonds, then the Fed determines which are the best fit for their program. We’ll know at the end of the day how many bonds were offered by dealers and how many the Fed bought for the program.

The 2009 total amount purchased by the Fed as of yesterday’s close is just under $44 billion in Treasuries. This program is designed to keep rates low and the Fed will remain active in this arena. They have $256 billion more to spend and they plan to be in the market two to three times per week buying Treasuries. All this talk about Treasuries might make you forget that the Fed also plans to purchase more than $1 Trillion in Agency debt. The end result is that rates are low and the government is going to do everything they can to keep them low.

Inflation concerns are what will cause the yield curve to steepen and ultimately cause the Fed to begin raising rates to fight it. The PPI numbers this morning coupled with advance retail sales data paint a picture of an economy that is not about to begin sprinting. There is nothing inflationary in this morning’s economic data. Bernanke’s remarks on the economy this morning were intended to put a more positive spin on our current situation. Essentially he believes that the pace of the decline in business conditions is slowing. Essentially he says we are no longer in a “sharp decline”, but have moved into a period of slower decline. So still falling, just not as fast. Bernanke perceives this to potentially be a sign of the first step toward recovery.

Below are this morning’s economic releases. All releases posted numbers worse than the Bloomberg estimates.

MBS Spreads

MBS spreads have collapsed from their highs back in November of 2008. Calmer markets and massive purchases by the Fed are two of the factors that have combined to push these spreads tighter. Driving spreads on MBS product tighter to the Treasury curve is an essential piece of the government’s plan to drive down borrowing costs. You’ll recall that they have committed to spend north of $1 Trillion on Agency product…most of it on MBS.

Keep in mind that prices and spreads move in opposite directions so the lower that spread goes, the higher the price of the bond. All of this spread tightening has pushed prices higher on MBS product. This has given many banks an opportunity to sell bonds at very nice gains. Whether you need to fund loans, make earnings, or restructure some things in the portfolio there are a number of reasons one might take gains in this environment. If you have any questions about selling for gains in this environment just let me know and we can discuss recent activity in this area.

A quick look at the shape of the curve.

The graph below shows the spread between the 2-year Treasury and the 10-year Treasury going back to 1989 (as far back as Bloomberg will allow with daily data).

This is a graphic way to display the steepness of the yield curve over time. In the top panel of the graph below you will see periods with large gaps between the orange and white lines. These indicate periods with steep yield curves (a wider spread between the yield on the 10 year and that of the 2 year is by definition a steeper curve). The periods with small gaps indicate narrow spreads and represent flatter yield curves. You can see our current situation on the far right of that graph. While we have an overall low level of rates at the moment we’ve got a fairly steep yield curve with 200 basis points separating the 10 year and 2 year spots on the curve.

The bottom panel of the graph below is a different view of the same information. The bottom panel maps only the spread (not the actual yield levels of the two bonds). At the yield curves steepest point over the sample period, the spread widened out to 275 basis points (back in 2002). A steepening yield curve is an indication of rising rates on the horizon. Yields on the long end of the curve will rise as investors begin to price inflation into the picture.

With the Fed committed to keeping rates low and the market just beginning to price future inflation expectations into the yield , we’re at an interesting point in yield curve history. The last thing the Fed wants is higher interest rates…so we get the $300 billion Treasury purchase program. One has to wonder how effective the Fed can be in keeping rates low if we see a large change in sentiment on inflation. When the economic data begin printing inflationary numbers there will be a massive change in investor sentiment. Will $300 billion be enough to replace the demand of the investors that flee the long end of the curve? Time will tell. For now it looks like a nice time to keep things short.

If you have any questions on this material just let me know.