The spread between the two-year Treasury yield and a key interest rate set by the Federal Reserve is the narrowest in the depth of the coronavirus market, a potential sign of financial system stress.
The two-year Treasury yield, which closed at 0.133% on Monday, is 0.013 percentage points above the interest rate on excess reserves or IOER. It traded at 0.105% earlier in February. The Fed pays banks reserves held over and those imposed by central bank regulatory policy as part of its effort to maintain liquidity in the financial system.
When the coronavirus sent markets and the economy down in March, the Fed reduced the IOER by 1 percentage point to 0.10% – along with other interventions – to support short-term lending markets and support economic activity. The spread between the IOER and the two-year yield has typically been over 0.05 percentage points since the Fed cut the rate to its lowest level ever in March.
Traders said the decline in this gap reflects the appetite for short-term debt, while investors swallow safe assets and park their cash. It also highlights a key point of tension in financial markets: the extent to which Fed support for markets drives asset prices to unsustainable levels and how vulnerable it is to leaving bond markets and other areas exposed to sudden reversals.
Analysts tracked the results of the Treasury auction to assess whether rising tax expenditures and an increase in Treasury bond supply would lead to lower short-term Treasury prices and higher yields. So far, that hasn’t happened. But bond traders are worried that inflation could rise in the coming months and years as the government prints money to support the economy and cover the costs of future borrowing.