Who knew holding short-term Treasuries could be so exciting?
No sooner had I speculated this weekend that it seemed odd to observe all this talk of risk and still have such a modest premium associated with Treasury yields, then the market responded with a bang, with the yield on 3-month Treasury bills falling 60 basis points on Monday, putting it 160 basis points below the value we’d seen just the previous Monday.
One should I suppose attribute some of that movement to a sudden change in the expectation of where the Fed is going to be setting the funds rate over the next 3 months. But most of the move has to be seen as a dramatic rush away from risk, although, if I may say so without putting a new hex on the market, I might have expected to see some other riskier rates spike up along with the sharp move down in short-term Treasuries under that scenario. Maybe I’m looking for that spike up in the wrong series, or perhaps there is some credit rationing going on– much of the formerly risky borrowing is simply no longer taking place. In any case, the partial recovery in Treasury yields since Monday should be viewed as restoration of at least a bit more calm.
It’s also interesting that the effective fed funds rate has come down and stayed down:
When the Wall Street Journal speculated on Friday that the Fed had already implemented a “stealth easing” of interest rates, I was inclined to dismiss the idea. Given the massive reserve injection that the Fed had found necessary to provide the previous Friday, it would be hard for that not to create an overhang of excess reserves that would depress the fed funds rate for the remainder of that maintenance period. But we started a new maintenance period on August 16, and the Fed is still injecting reserves even though the effective funds rate is obviously ending up below the announced 5.25% target, making it pretty clear that whatever is motivating the Fed’s most recent open market operations, it is not an effort to keep the effective fed funds rate right at the announced target. My guess is that it is also not a simple effort to keep the effective funds rate at some other number such as 5.0%, either, but that instead the Fed is responding to specific concerns, perhaps related to the comment I made above about credit rationing. Although Bernanke has a commitment to openness about monetary policy in general, he would not be in a position to give us the details of any such concerns, since the Fed has to be very careful not to let its own announcements become the cause of a panic withdrawal of deposits or lending from institutions facing temporary challenges. Suffice it to say that the Fed likely has some real worries at the moment, and they’re not adequately summarized by just looking at the interest rate on a volume-weighted average of fed funds trades over a day.
Based on where fed funds have been trading so far this month along with today’s closing price of 95.015 for the August fed funds futures contract, the market seems to be expecting an average effective fed funds rate for the remaining days of August of 4.94%. The September contract (95.06) is predicting exactly the same thing for the following month, and lower values as we go on from there. I suspect that the period since August 10 will become one of those episodes where the series for what the fed funds “target” actually was will always be noted by an asterisk by scholars, because the Fed’s objective at the moment is something other than achieving any particular value for the effective fed funds rate. But whatever label you want to put on it, we’re not going to be seeing fed funds averaging 5-1/4 again any time soon.