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Crescenzi: Why Treasuries are Getting Hit

U.S. Treasuries have fallen sharply of late, with yields across the yield curve moving to their highest level since last December. Yields on short maturities have moved up the most, reflecting increased expectations for a reversal in Fed policy, such that investors are now expecting the Fed to eventually raise interest rates rather than lower them. This is evident in federal funds and Eurodollar futures, which are priced for a single quarter-point rate hike occurring in the fourth quarter of this year, and for as many as two additional hikes in the first quarter of 2009. Much of the recent increase in Treasury yields reflects these sentiments, which are rooted in both the recent improvements in the credit environment and an intensification of worries about inflation.

Treasury yields have been climbing ever since bottoming for 2008 on Monday, March 17th, which of course was the first day of trading following the Bear Stearns rescue. The 10-year's yield has climbed 69 basis points since then to 4.0% from its low of 3.31%. The yield on 2-year notes has increased much more, by 126 basis points to 2.60%, which of course means that the yield curve has flattened since then. It has done so because the Federal Reserve is no longer seen as cutting interest rates and because the flight-to-safety trade has moved in reverse since March. The increase in yields on 5-year notes has been 114 basis points, a very sharp increase in relation to the 2-year given its flattening to 10s, reflecting the fact that 5s tend to shine on the way up and get hammered on the way down (many entities are not allowed to invest beyond 5 years, which makes the 5-year an obvious target to overweight and underweight depending upon the interest rate outlook).

A major factor pushing Treasury yields higher in recent weeks has been a flight to other segments of the fixed-income markets. In the corporate bond market, for example, the issuance of company bonds has increased dramatically, with issuance topping $30 billion per week since the Bear Stearns rescue, which is roughly $10 billion above normal. In two of the weeks since then, issuance topped $45 billion, making those weeks the two best ever in the corporate bond market. Even high-yield issuers have gotten into the act, selling more bonds in a single week than at any time since last November.

The impact and message from the increase in corporate bond issuance is multifold. For one, the increased issuance produces a crowding out effect, reducing the amount of dollars available for investing in Treasuries. Second, the fact that the new issuance went extremely well indicates that investors have become more willing to move out the risk spectrum. Third, the issuance will benefit the economy, improving the outlook and dampening the chances at further interest rate cuts.

The credit environment in general has improved substantially from its worst point, cutting the demand for Treasuries. The improved environment is apparent in the increase in bond issuance that I mentioned and in gauges such as swap rates, where the swap market has improved sharply from its third distinct episode of fear -- with August, November, and March representing the three major periods of heightened anxiety.

Important also has been the decline in 1-month LIBOR, which has fallen sharply ever since the Fed increased the size of its Term Auction Facility to $150 billion per month beginning in May from $100 billion in March and April, $60 billion in January and February, and $40 billion in December. Today, 1-month LIBOR is trading at 2.38%, down 12 basis points in two weeks time and 51 basis points in May alone. With the Fed's Term Auction Facility (TAF) priced at 2.10% in the latest week, there is room for additional, albeit smaller, declines (the Fed auctions loans to banks via its TAF).

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Healing in the credit markets has strongly influenced perceptions about the direction of monetary policy, but so has the recent acceleration in inflation and inflation expectations. Last week, for example, the market for inflation-protected securities was priced for the consumer price index to increase at a pace of 2.57%, the most since August 2006. The ever-increasing level of energy prices has obviously had significant influence on inflation views.

There is room for additional increases in yields in the weeks and months to come. The 2-year note provides good guidance about how far yields can go. Most times (these are not most times because the funds rate has been brought low), a yield spread to fed funds of 50 basis points signals 50/50 chance that the Fed's next move will be either a hike or a cut. At 75 basis points over funds, the market is priced for high odds that a hike will be delivered within a few months but not more than six months away. At 100 basis points over, a hike is seen as imminent. These rules change a bit when the funds rate is unusually low, as it is now, so the scale at which 2s, and hence the rest of the yield curve can trade higher in yield must be moved up a bit. In other words, 2s could move to 125-150 basis points over funds when a hike is imminent, meaning that neutrality on monetary policy is defined as 62.5 to 75 basis points over funds. Hence, if 2s move higher than these boundaries and the case for a hike is good, then the yield rise will be justified. If not, look for Treasury yields to steady in that zone.

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Tony Crescenzi is the Chief Bond Market Strategist at Miller Tabak + Co., LLC where he advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. Crescenzi makes regular appearances on financial television stations such as CNBC, and is frequently quoted across the news media. He is also the co-author of the just-revised "The Money Market" and "The Strategic Bond Investor."

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