Monday, 1 December 2008

The US yield curve: the “mirror” of the financial conditions

US Yield Curve (29/10/2008), source: Financial Times website

by Juan Pablo Painceira

The importance and hegemony of the US dollar within the global financial system has become the subject of much debate in recent years. As a consequence of the financial crisis the dollar’s position as the world currency has been analysed and challenged by some analysts, for example N. Roubini ( However, another important analytical tool to understand recent movements in the financial markets has been neglected, namely the US Treasuries yield curve. This curve can be seen as a “mirror” of US financial conditions. This is because the state bonds market – and in particular US public securities - has been the key element in the expansion of finance around the global economy in the last 30 years. It has been also the benchmark for other capital assets.

The yield curve has taken on an unusual shape since the beginning of September (around 10th), as there is now a “dent” around the maturity of 2 years. Since then there has been a gradual move towards a “normalization” of the US yield curve, but this anomaly has persisted ( Although the causes are complex –for example the effects of other financial markets such as money market and corporate bonds market – there are some clear short term short term and long term drivers for what has happened.

Short-term, the expectation of rate cuts has driven investor bets towards the short-term part of the curve, implying that there has been a risk premium in the yield curve, mainly around the maturity of 1 and 2 years. It is important to note that the new market for one year T-bills (officially called 52 week bills) was reopened only in June 2008, with the previous auction in February 2001. Another point is that the freezing in the money markets has slashed short-term interest rates, reflecting banks’ preference for hoarding cash and very liquid government bonds.

Longer term, the strong demand for Treasuries around 2 and 3 year maturity can be related to problems in corporate bond markets, where companies have had huge problems in getting finance. The corporate sector has also affected the shortest-term part of the yield curve through the crunch in the commercial paper market (securities up to 90 days market). The Federal Reserve’s balance sheet has showed an increase in what it terms its “other loans” item, where the total amount of securities with maturity over 1 to 5 years is now around $70 billion.

The huge drop in bond issuance in the corporate markets is important for ordinary people as even the biggest companies have had difficulties in accomplishing the simplest of obligations, for example their payroll! It is the main reason why the Federal Reserve has intereved in the corporate bond market through financing operations in the same way it usually does with financial institutions, mainly commercial banks. These operations are called repo operations, where the FED accepts the securities in exchange for cash for a pre-determined period of time. In another words, the Federal Reserve will be acquiring companies’ bonds in order to finance them for a certain period of time.

Finally, the aggressive emphasis on the steepening of the yield curve is related to the recovery of banking industry profitability, where we have the traditional “borrow short and lending long” strategy. However, the Fed has only succeeded in returning the yield curve to its normal shape (upwards) after 2 years maturity, and the fed funds rate has not followed this drop.

This emphasis can be also connected with the banking bailout plans around the global economy, as public financing for the banking recapitalizations is much cheaper. It happens because the US Treasury has been focused on short term financing in its strategy of debt management - the reoffering of 52 week bills and the release of new 3 year treasuries notes are a good example. The main assumption underlining this strategy could be related to the US authorities’ expectations on the final resolution of the financial crisis. As we can see, the US yield curve has much to tell us about conditions in the broader financial markets and economy.