Economic Commentary

In case you haven’t noticed, Treasury and mortgage yields are on the rise. There is no shortage of possible causes: cessation of the Fed’s year-old, $1.25-trillion MBS purchase program, insecurity over the burgeoning amount ($1.6 trillion) of government debt that Treasury will be selling this year, plus overall concern that Washington is paying lip service to those, including foreign creditors, that are subsidizing a current structural budget deficit that is 11% of annual GDP.

Prompted by the latter statistic, a particularly loud alarm sounded in the interest-rate swap market last week, with investors in Treasury bonds being compensated at a higher rate than receivers of corporate bond yields! Could it be that the financial markets have finally concluded that the budgeting skills and repay ability of standalone private enterprises eclipse those of a certain sovereign issuer?! Indeed, 10-year swap rates, from floating payments to fixed payments, fell below comparable Treasury yields last week. At one point, swap rates were over 10 basis points below Treasury yields. Hence, the financial markets may have found a new gauge of concern in the form of swap spreads, for sovereign default risk and growing fiscal deficits.

While the long-end of the yield curve is telling its own story in the form of 10-year Treasury yields approaching 4.00%, their highest levels since June 2009, the Federal Reserve continues to signal an accommodative monetary policy. The reason still lies in the employment situation. During last week’s Congressional testimony, Ben Bernanke re-confirmed the longstanding view that “the employment situation is very weak.” In particular, with cumulative job losses of 8.4 million, he cited the continuing rise in long-term unemployment. At least for the short-term, however, we are beginning to see signs of improvement in the labor picture, with last week’s number of unemployed workers seeking assistance at the lowest level since December 2008.

If indeed an economic recovery is within our grasp, the question will soon focus on how to get the genies of monetary and fiscal excess back in the bottle. On that score, the Fed has indicated that asset sales will play a meaningful role in trimming its $2.3 trillion balance sheet. In early 2007, at the beginning of the financial crisis, the size of the Fed’s balance sheet stood just shy of $900 billion (virtually all of which was invested in Treasury securities). The balance sheet grew substantially during the financial crisis, largely due to the $1.4-trillion purchase of mortgage-related debt. Many would argue that, in order to avoid charges that it is beholden to political pressures and has foregone its independence, the Fed should sell a portion of its assets in coming months. An additional supply of mortgage-related debt coming on stream could imply higher rates, yet would benefit the financial markets as a demonstration that the Fed views future inflation as an unacceptable option. Other shows of force that the Fed could use to demonstrate restraint against future inflationary prospects could include increasing excess reserve rates and sales of deposits to banks (much in the manner of the Fed selling a term CD that a bank could portfolio as an investment).

In the weeks ahead, foreign investor participation will weigh heavily. During last week’s Treasury auctions, interest on the part of the Chinese and Japanese central banks was minimal. This could have incorporated the non-recurring impact of Japan’s March 31, 2010, fiscal year-end. As an example, auction levels on seven-year Treasuries increased by 25 basis points month-to-month. “Greece” will continue to be the word, as well, as the mere mention of an advanced economy and a member of the European Union potentially requiring assistance from the International Monetary Fund sends shivers up the spines of sovereign debt holders.

John P. Biestman, CFA, is director of business development at the Federal Home Loan Bank of Seattle.