The prices of United States Treasuries fell last week as a fresh supply of government notes and bonds hit markets. However, the Federal Reserve's commitment to keep short-term interest rates low for an extended period is likely to limit further downside.
At its last monetary policy meeting last month, the Fed reiterated its expectation that the federal funds rate will stay at exceptionally low levels for an "extended period". However, its emergency programmes implemented at the height of the financial crisis will be gradually wound down, including those for the purchase of securities.
A commitment by the Fed to keep the federal funds rate low would, in most times in the past, have been enough to keep yields on longer-term Treasuries low.
The accompanying chart shows how, over each of the years from 1955 to 2009, the change in the 10-year Treasury yield (shown on the vertical axis) has varied with the difference between the change in the federal funds rate and the spread between the 10-year yield and the federal funds rate at the beginning of each year (shown on the horizontal axis).
Assuming that the Fed keeps the federal funds rate unchanged for the rest of the year, the expected change in the 10-year yield in 2010 -- represented by the red square -- is negative.
Still, these are not normal times.
Fiscal stimulus to maintain the current economic recovery on top of on-going budget deficits is forcing the US government to sharply increase the sale of government securities. The US government has projected that the US budget deficit will rise from US$1.4 trillion in 2009 to a record US$1.6 trillion this year and the public debt will rise from US$7.5 trillion at the end of 2009 to US$9.3 trillion in 2010.
The past week perhaps provided a foretaste of things to come.
US Treasuries fell last week as the government sold US$81 billion in notes and bonds. The yield on the 10-year Treasury note rose 13 basis points to 3.69 percent. The 30-year bond yield also increased 13 basis points to 4.65 percent.
The sale of US government securities fetched yields that were higher than expected as the increase in supply pushed down the prices of Treasuries. The sale of US$40 billion of three-year notes, US$25 billion of 10-year notes and US$16 billion of 30-year bonds drew yields of 1.377 percent, 3.692 percent and 4.720 percent respectively, all of which were higher than forecasts in Bloomberg surveys of bond-trading firms.
A flight to safety probably mitigated the rise in US Treasury yields last week as the euro area remained rocked by uncertainties created by the debt problems in Greece and other eurozone countries.
Still, not all recent events in other countries are helping to keep interest rates in the US down.
Yesterday, China celebrated the start of the Year of the Tiger but investors received no presents from Chinese policy-makers to start the new year with. Quite the opposite, in fact.
Last Friday, the People's Bank of China announced that the reserve requirement for financial institutions will be raised by 50 basis points on 25 February. The increase will bring the rate for large banks to 16.5 percent.
This was the second time in about a month that the PBC has raised the reserve requirement. It had also raised the requirement by 50 basis points on 18 January.
The Reserve Bank of Australia has been even more aggressive in monetary tightening, raising interest rates three times last year. It left its overnight cash rate target unchanged at 3.75 percent after its latest monetary policy meeting in February but indicated that interest rates would be "adjusted further" to keep inflation within the central bank’s target range of 2 to 3 percent.
As central banks around the world unwind emergency levels of monetary stimulus initiated during the financial crisis, global interest rates are likely to rise.
Having said all that, the federal funds rate at near zero provides a powerful anchor for US Treasuries and the recent increase in yields for the latter are unlikely to be sustained for very long.
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