The difference between short- and long-term U.S. Treasury yields narrowed Tuesday as central bank efforts to alleviate liquidity shortages removed some of the impetus to buy safe-haven short-term debt.
Long-dated maturities made some gains, but shorter-term debt was steady on expectations that the central bank measures to make more money available in the interbank market would lessen the need for additional cuts in official interest rates.
The Fed conducted the first of four planned funding auctions on Monday, essentially allowing banks to borrow cheaply and anonymously to encourage them to continue lending to businesses and keep the economy growing.
Tentative signs that the funding auctions were having the desired effect, including a sharp pullback in European money market rates following a massive cash injection by the European Central Bank, kept two-year note yields were steady at 3.19 percent
"There's some sense in the markets that the efforts of the European Central Bank and the Federal Reserve to pour liquidity into the market will help to resolve the interbank funding problems so that hurt the front end," said Ward McCarthy, economist and managing director at Stone and McCarthy Research Associates in Princeton, New Jersey.
Some curve steepening trades were also unwound, McCarthy said, requiring selling at the front end and buying instruments farther out on the maturity curve as a consequence.
A mid-afternoon stock market recovery reduced the gains of long-dated Treasuries as investors showed more willingness to acquire riskier assets.
Benchmark 10-year notes were up 6/32, for a yield of 4.13 percent percent, down from 4.15 percent. This narrowed the gap between short- and long-dated yields by four basis points from late Monday, flattening the yield curve.
"With central banks pumping liquidity and Libor resets falling, the curve will likely continue to flatten in the short-term," said Frank Hsu, director of global fixed income at Fimat.
At the very least, a sense that the world's central banks were making a concerted effort to shake loose some liquidity relieved investors, to the detriment of government debt.
"It's better than doing nothing," said Albert Safdie, global fixed-income trader at Hapoalim. "Under no circumstances can a world afford to have a disruption of funding."
Some skepticism of the central bank initiative remained, nonetheless, with a much more moderate reaction in U.S. and British rates. Analysts worried the short-term measure would not address the underlying mistrust that has frozen the banking system.
The crisis began with rising mortgage default but quickly spread to the complex bond structures that Wall Street had carved out of the underlying loans.
The extent to which the crisis spreads will depend in part on the performance of the housing market, where falling home values could increase financial losses.
The investment bank Goldman Sachs Group, for instance, cautioned on Tuesday that markets will remain challenging in the near future, citing continued "dislocation in some of the world's capital markets." Goldman also said that the subprime crisis was not yet over.
Supporting that view, the Commerce Department reported that housing starts fell 3.7 percent in November as the pace of single-family home construction slowed to its weakest in 16 years. Building permits fell to their lowest rate since 1993.