Market prices convey signals on what investors are thinking. In the bond market, fixed income traders are not happy. Look at money markets. Short-term LIBOR rates shot up during the credit crisis in August but moved down after action taken by the Fed and a general perception on the limited extent of the crisis. However, credit crisis uncertainty has not abated. The crisis has lead to continued write-downs of CBO’s and a lack of liquidity in the commercial paper market. LIBOR rates are again on the march upward. The spread between Fed funds and LIBOR has actually increased and now moving back to the highest levels since August. Now it is natural that the spread will increase after a Fed action. LIBOR will usually follow Fed funds and not lead the rate, but currently, short-term LIBOR spreads are moving higher on growing credit risk. There seems to be special concern about the year-end turn.
The Treasury curve is signally a significant slowdown in growth. The curve changes have not been driven just in the front-end but have been a general parallel shift down in rates. Treasury yields are actually lower than Fed funds across the board which is out of the ordinary. By this standard, the Fed is actually tight with monetary policy. Put another way, the fixed income markets have a significantly less rosy picture on the economy than anything that is being forecasted at the Fed. We know that the Fed has a relatively rosy picture because their latest forecast as part of the new transparency does not show any recession but just growth below trend for the next two years.
The Fed has responded with a temporary injection of funds of approximately $8 billion which is similar to recent action taken. The objective is to ensure liquidity through the end of the year. Year-end volatility may be especially large this year because of clean-ups of the balance sheet. More Fed action will be needed to alleviate fears in the fixed income market.
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