Meet the New Year, same as the old – with a twist.
In preparing our treasury investment strategy outlook for 2011, it seems there isn’t much we have not already seen or experienced in 2010 – an exceptionally low interest rate environment, the Eurozone sovereign debt crisis, and a wave of financial regulations. Indeed, we have written about these themes on several occasions. However, complacency can sometimes have a nasty hangover, especially in this profession. In the interest of keeping a healthy dose of skepticism to the consensus view, we feel obliged to offer our take on trends, as well as “twists,” in cash investments in the New Year.
Exceptionally low interest rate environment creates yield opportunities further out on the yield curve.
It has been more than two years since the Federal Reserve took the benchmark Fed funds rate down to a range between 0% and 0.25% in December 2008. It is one thing to marvel at the survival of the short-term debt market at these exceedingly challenging levels. It’s another trying to gauge when the rates will start to rise, or at least are poised to rise. For much of 2009, and the early part of 2010, the Fed and the markets were getting ready for the eventual arrival of sustained economic expansion and a rising interest rate environment. Alas, the dynamic duo of the Eurozone sovereign debt crisis in the spring and the expiration of housing tax credit in the summer crashed the party. Currently, the Fed is set to complete round two of its $600 billion Large-Scale Asset Purchases (LSAP, also known as Quantitative Easing 2) in long-term Treasury securities by June 2011. By then, the Fed’s balance sheet will stand at approximately $3 trillion.
The trend: Since the central bank has made it known that it will deflate its balance sheet before embarking on interest rate increases, it is sensible to expect the Fed funds rate will remain immobile for much of 2011 and perhaps even through the early part of 2012. Hence, the low interest rate environment will likely be with us for another year. Investors of money market funds, short-maturity Treasuries, and bank deposits may have another lackluster year ahead for them.
The twist: Since the Fed’s announcement of Treasury purchases at its November 3rd policy meeting, the yield curve has actually steepened, meaning yields on short maturity Treasury bills remain low but longer-term rates are rising (See Figure 1). During this period, the 3-month Treasury bill rate was unchanged but the 2-year note yield doubled to 0.66%. There are several explanations for this trend: a) economic activities have turned more positive since early November; b) markets are concerned that the Treasury purchases may stoke future inflation; and c) the $858 billion cost of the recently enacted extension of Bush-era tax cuts will be financed entirely with new Treasury debt.
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