The spread between the two-year treasury yield and a core interest rate set by the Federal Reserve is the smallest since the depth of the coronavirus market sale, a possible sign of tension in the financial system.
The two-year treasury yield, which closed at 0.113% on Monday, is 0.013 percentage point above the interest rate on excess reserves, or IOER. It traded up 0.105% earlier in February. The Fed pays banks on the reserves in addition to those required by the central bank’s regulatory policy, as part of its effort to maintain liquidity in the financial system.
When the coronavirus hit markets and the economy in March, the Fed cut the IPO by 1 percentage point to 0.10% – along with other interventions – to sharpen short-term lending markets and support economic activity. The spread between IOER and the two-year yield has typically been higher than 0.05 percentage point since the Fed lowered the rate to its lowest level ever in March.
Traders said the shrinkage of this spread reflects the appetite for short-term debt as investors eat safe assets and park their cash. It also highlights a key point of tension in the financial markets: the extent to which the Fed’s support for markets is taking asset prices to unsustainable levels, and how vulnerable it is exposing bond markets and other areas to sudden reversals.
Analysts have been watching the results of the Treasury auction to determine whether increased fiscal spending and a supply push of Treasury bonds will cause short-term treasury prices to fall and yields to rise. So far this has not happened. But bond traders are worried that inflation could rise in the coming months and years as the government pushes money to support the economy and cover future borrowing costs.