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What I did here was take selected points on the Treasury yield curve (1mth, 3mth, 6mth,
1yr, 2yr, 5yr & 10yr) and graphed out its shape on a daily basis for the past 5 years to
create a 3‐D surface. God, I love SAS.
The idea here is to analyze how the yield curve’s shape has changed over time. As you can
see, a dramatic steepening of the curve has occurred with the unprecedented amounts of
Fed liquidity. With talk of the Fed removing that liquidity, it’s time to start thinking about
what that actually means for interest rates. Because at the end of the day, interest rates
drive borrowing and investing decisions – asset prices are just a function of the rate
environment we find ourselves in.
1
CMT Treasury Yields – 5 Years (cont’d.)
Here I rotated the surface & reversed an axis to show the rise in the 10 yr. CMT yield which
you can see circled here. The rise is characterized as an expectation of inflation to start
rearing its ugly head in the future. If interest rates just gave an indication of inflation
expectations, I’d probably find that conclusion hard to argue with. But interest rates are
not just reflective of inflation, they’re also a reflection of other risks.
2
Risks Captured in Bond Yields/Rates
• Default Risk
• Migration Risk Components of Credit Risk
• Credit Spread Risk
• Liquidity Risk
• Inflation Risk
• Basis Risk
• Others (optionality, event, etc.)
I wanted to build this list because I’m trying to illustrate a point: inflation is just one risk
interest rates/bond yields are trying to capture. There’s a host of other risks out there. Up
to this point I’ve been talking about Treasuries pretty extensively. However, considering
the different types of risks embedded in yields/interest rates, Treasuries may not be well‐
suited to capture them. So we need to look at something else.
3
Swap Spread Curve from 10/04
Here is the swap spread curve (LIBOR – corresponding Treasury CMT yield) as a surface. I
used the 1mth, 3mth, 6mth & 1yr LIBOR & corresponding Treasury CMT yields to look at
the term structure of the curve.
You’ll note the period where the surface shows the 1‐3mth spread higher than the 1yr
spread which occurred last year. The inversion is a sign of stress when you deal with rates.
In this case, it shows sheer panic. Because it’s not a rate, it’s a spread over Treasuries
which are assumed to be the closest thing there is to a riskless asset.
Look at where it was and then look at the front end of the surface that shows a normalized
slope with the shortest duration spreads smaller than the longest ones. Then ask one
simple question: Is there really that much less risk out there now than 12‐18 months ago?
4
1Y LIBOR ‐ 1Y TSY Spread
(%)
3.75 3.75
3.00 3.00
2.25 2.25
1.50 1.50
0.75 0.75
0.00 0.00
05 06 07 08 09
Source: Haver Analytics
Here is one piece of the surface, the swap spread at 1 yr. All of the liquidity that has been
pumped into the system has brought the spread back to right before Bear Stearns was
taken under by JPMC. And I’m not sure how long the spread will stay settled around 80
bps. Trillions at risk on the Fed’s balance sheet and this is what it bought us? It’s nuts.
5
1mth LIBOR ‐ 1mth TSY
(%)
5 5
4 4
3 3
2 2
1 1
0 0
05 06 07 08 09
Source: Haver Analytics
Here’s the 1mth swap rate, notice this spread has gotten back to pre‐’07 levels.
6
Federal Reserve Balance Sheet: Term Auction Credit, Other Loans & Other Assets
(trillion s)
1.50 1.50
1.25 1.25
1.00 1.00
0.75 0.75
0.50 0.50
0.25 0.25
0.00 0.00
08 09
Source: Haver Analytics
Here’s my concern: this chart. I added the Term Auction Credit, Other Loans (which
contains loans from the Primary Dealer Credit Facility, which is not being tapped & hasn’t
for some time, to my relief), and another line item called Other Assets. I have no idea what
that Other Assets is, but it has grown significantly and I show it on the next page.
But the problem I keep coming back to is this: most of these facilities were short‐term
facilities. Some of them have been – or are being – wound down. That’s good. But there
are still hundreds of billions of dollars they are sitting on in MBS that I fear may be
impaired – so the government has to step in & guarantee them.
But nobody sees any implications for short‐term rates? People need to understand slide 3.
The unwinds of these facilities point to a less liquid market as the Fed lets them expire.
So if the market is still liquidity constrained, how does the short‐end of the curve not move
higher in terms of rates?
7
Reserve Bank Credit: Other Federal Reserve Assets
A vg, Mil.$
100000 100000
80000 80000
60000 60000
40000 40000
20000 20000
05 06 07 08 09
Source: Federal Reserve Board /Haver Analytics
Just to highlight the question about what this is and how did the stuff end up here. This is
one of the reasons why the Fed *must* be subjected to outside validation because the Fed
saw fit to commit taxpayer money in the manner it did, yet there’s no independent review
of their effectiveness and whether or not the valuations they carry for the collateral
pledged to the Fed are appropriate? Again, nuts.