The spread between the two-year Treasury yield and a basic interest rate set by the Federal Reserve is the narrowest since the depths of the coronavirus market liquidation, a potential sign of stress in the financial system.
The two-year Treasury yield, which closed Monday at 0.113%, is 0.013 percentage points above the interest rate on excess reserves, or IOER. It was traded at a low of 0.105% in early February. The Fed pays banks on reserves held above and beyond those required by central bank regulatory policy, as part of its effort to maintain liquidity in the financial system.
When the coronavirus caused markets and the economy to screw up in March, the Fed cut the IOER by 1 percentage point to 0.10% – along with other interventions – to strengthen short-term loan markets and support economic activity. The spread between the IOER and the two-year yield has normally been above 0.05 percentage points since the Fed cut the rate to its lowest level in March.
Traders say the narrowing of this spread reflects an appetite for short-term debt as investors swallow safe assets and park their money. It also highlights a key point of tension in the financial markets: the extent to which the Fed’s support for markets is bringing asset prices to unsustainable levels and how vulnerable it leaves bond markets and other areas exposed to sudden reversals.
Analysts have been looking at the results of Treasury auctions to assess whether increased fiscal spending and a wave of Treasury supply would push short-term Treasury prices down and yields to increase. So far, this has not happened. But bond brokers are concerned that inflation will rise in the coming months and years, as the government prints money to support the economy and cover future borrowing costs.