In response to the slowing recovery, the Federal Reserve announced yesterday that it would use yet another weapon in its arsenal to keep the economy from slipping back into recession. In addition to repeating its outlook of the last 17 months, that weakness in the economy will keep the fed funds rate at “exceptionally low levels” for an “extended period,” they will also begin buying longer dated Treasury paper.
From August 2008 to the present, the Federal Reserve’s balance sheet increased to nearly $2.4 trillion–about $1.3 trillion of which is mortgage backed securities. As this mortgage backed paper pays down, they will use the proceeds to buy longer dated Treasury Notes and bonds. After the announcement, the effect on the Treasury market was immediate: the 10-year Treasury Note yield has fallen from 2.83% on Monday to 2.72% today. Less than two months ago the 10-year Note yield was 3.30%.
Municipal yields have also been affected. The average “AA” rated, 10-year GO bond yield is 2.70% today; In mid-June it was 3.22%. Presumably, investors are discounting recent media stories about the imminent wave of municipal defaults and are growing more comfortable with the lower yield levels. While nobody can predict the future, a “tsunami of municipal bond defaults,” as Bloomberg news cited, is unlikely in our view and if it does occur, would most likely be contained within the usual sectors that buckle under pressure–but that’s a topic for our next market update–Stay Tuned.
Jeffrey D. Irish
Bernardi Securities, Inc.
August 11, 2010