The difference between two-year Treasury yields and a Federal Reserve base rate is the smallest since the depths of the sell-off of the coronavirus market, a possible sign of stress in the financial system.
The yield on two-year government bonds, which closed at 0.113% on Monday, is 0.013 percentage points above the interest on excess reserves, or IOER. It hit a low of 0.105% earlier in February. The Fed pays banks on the reserves held above and beyond the reserves required by the central bank’s regulatory policy as part of its efforts to maintain liquidity in the financial system.
When the coronavirus sent markets and the economy into a tailspin in March, the Fed cut the IOER by 1 percentage point to 0.10% – among other interventions – to bolster short-term loan markets and bolster economic activity. The difference between the IOER and the two-year rate has typically been above 0.05 percentage point since the Fed cut interest rates to its lowest ever level in March.
Traders said the decrease in this spread reflects interest in short-term debt as investors gobble up safe assets and park their cash. It also highlights a major point of tension in the financial markets: to what extent is the Fed’s support for markets that are pushing asset prices to unsustainable levels, and how vulnerable are bond markets and other areas exposed to sudden reversals?
Analysts have been watching government bond results to gauge whether higher budget spending and an increase in Treasury bond supply would weigh on short-term Treasury prices and raise interest rates. This has not happened so far. But bond traders are concerned that inflation could rise in the coming months and years if the government prints money to support the economy and cover future financing costs.