Lots of Action in the Bond Market

This is just a brief note to make you all aware that it’s being a very remarkable week in the Land of Fixed-Income and Monetary Policy.

I’ll post much more on this topic as soon as I can, but the Federal Reserve has qualitatively changed the nature of their response to the financial crisis. As of this week, they’ve embarked on what is called “quantitative easing” of monetary policy.

To oversimplify somewhat, they’ve transitioned from trying to effect policy by manipulating the price of credit, to directly creating credit themselves. This is by way of the flurry of new facilities they announced yesterday.

You can see for yourself one of the immediate consequences: yesterday morning, retail mortgage rates dropped almost 90 basis points. In most parts of the country, you can get a 30-year fixed rate mortgage for about 5.30%. It remains to be seen whether this will lure buyers back into the housing market, but it’s a hopeful sign.

Elsewhere, the Treasury has gone into overdrive, creating vast new supplies of the most desired asset class in the world, namely full-faith-and-credit US Treasury paper.

We’re going to see the yield curve flatten considerably in the near term. The Fed funds rate (which is currently targeted at 1%) is actually near zero. This limits the ability of short-dated paper (like T-bills) to increase in value.

Meantime, there is a lot of new supply hitting the 3-year sector of the curve. Treasury is now issuing new 3-year notes every month, and the new banks on Wall St. (which used to be investment banks) are issuing 3-year notes with an FDIC guarantee. That’s going to push up yields at this maturity.

And then there’s the Fed, which is out there buying up long-dated securities like Fannie/Freddie debt and mortgage-backed securities, and securitizations of consumer debt (student loans, credit cards, car loans). This will take sone supply out of the long end of the market and keep yields low.

More later.

-Francis Cianfrocca