MFR overview of markets
Compared to the immediate past, today was a comparative yawn. Markets were orderly, and the Federal Reserve did not need to inject large amounts of liquidity into the system (and indeed announced that it would redeem $5B of T-bill holdings on Thursday). With that said, fear continues to be the sentiment du jour, best evidenced by a sharp drop in Treasury bill yields, propelled by money market funds jettisoning more risky paper in favor of bills. The current one-month bill fell about 70bp in yield to close at 2.25% (and actually hit a low yield of 1.27% near mid-day), while the current three-month bill also fell by about 70bp, closing at 3.04% (and hitting a mid-day low of 2.50%). A late-day bounce by stocks helped to limit gains elsewhere in the curve. Twos closed at 4.10% after opening at 4.18% and hitting a low of 4.05% early in the afternoon, threes closed at 4.17% after opening at 4.24% and reaching a low of 4.12%, tens closed at 4.64% after opening at 4.68% and reaching a low of 4.61%, and the bond closed at 4.98% after opening at 4.99% and hitting a low of 4.95%. With flight-to-quality still occurring, the curve steepened as twos outperformed tens, bringing the 2-10 slope to 54bp from closes of 50bp on Friday, 44bp on Thursday, 35bp on Friday, August 10, and 26bp on Friday, August 3.
With the spread of twos to the Fed funds target a whopping 115bp, and Fed funds futures pricing in 75bp of Fed ease by year-end, markets clearly believe that turmoil in the credit markets will have a significant impact on real economic activity and that the Federal Reserve will be forced to act in a decisive manner. With the Fed saying on Friday that it was prepared to act as needed to aid the economy, this is not an unreasonable bet given the uncertainty surrounding markets and economic activity. However, being not unreasonable is not the same as being a sure thing. Mr. Bernanke et al are surely anxious to avoid continuing the infamous Greenspan put, and therefore are unlikely to ease policy by as much as the markets are currently pricing in unless the economy truly careens into a ditch.