4.5% 2 year T bill and Credit Risk on Money Market Funds

[PairTheBoard]

I was just listening to the CNBC Bond expert. He was being questioned about the 4.5% yield on 2 year Treasuries. The question presented the theory that the 2 year yield should equate to what the average Fed Funds Rate will be over the next 2 years, thus indicating some major Fed rate cuts in the next 2 years. The Bond expert said, No. That's not right. What's really happening is the pricing in of Credit Risk on super short term debt, I assume like that which Money Market Funds hold.

If it's true that the low 2 year Treasury yield is pricing greater risk on Money Market type Funds, then I'm puzzled. Why should Money Market Funds be any more risky than they've ever been, which I've always understood to be practically no risk? Has the Treasury Bond market gone overboard pricing risk here? In which case, shouldn't there be an arbitrage oportunity? Or is the 2 year Treasury Bond really signalling some heavy Fed Rate cuts over the next 2 years?

I don't think the observation that liquidity is just being parked in Treasuries right now really explains the situation. If the market thinks Fed Funds will not average 4.5% over the next 2 years then liquidity should be using the Money Market parking lot rather than Treasuries. That is, unless the market sees Money Market Funds as being at higher risk than in the past.

PairTheBoard

[DcifrThs]

[ QUOTE ]
I was just listening to the CNBC Bond expert. He was being questioned about the 4.5% yield on 2 year Treasuries. The question presented the theory that the 2 year yield should equate to what the average Fed Funds Rate will be over the next 2 years, thus indicating some major Fed rate cuts in the next 2 years. The Bond expert said, No. That's not right. What's really happening is the pricing in of Credit Risk on super short term debt, I assume like that which Money Market Funds hold.


[/ QUOTE ]

that assumption is incorrect. the credit risk pricing in doesn't affect MM asset riskiness, it relates to the fact that as credit markets experience large volaility and big negative jumps in spreads, people would rather hold risk free debt and pile into short term treasuries.

thus price of those bonds jump and, correspondingly, their yields fall.

Barron

[Uglyowl]

Fed Funds Futures are expecting two full rate cuts by May 2008. Here is what they are pricing into Fed Funds rates (subtract price from 100 to get your expected fed funds yield, it is pretty close to correct).

Sep-07 5.20
Oct-07 5.16
Nov-07 5.07
Dec-07 4.99
Jan-08 4.94
Feb-08 4.83
Mar-08 4.85
Apr-08 4.80
May-08 4.75
Jun-08 4.73
Jul-08 4.71

[DcifrThs]

[ QUOTE ]
Fed Funds Futures are expecting two full rate cuts by May 2008. Here is what they are pricing into Fed Funds rates (subtract price from 100 to get your expected fed funds yield, it is pretty close to correct).

Sep-07 5.20
Oct-07 5.16
Nov-07 5.07
Dec-07 4.99
Jan-08 4.94
Feb-08 4.83
Mar-08 4.85
Apr-08 4.80
May-08 4.75
Jun-08 4.73
Jul-08 4.71

[/ QUOTE ]

a) you seemt o know this so i'll state it for those who may be confused. you have the yield quoted here. so the price of the futures contract is 100-the yield you have quoted. the purchase of the contract is an agreement to receive for that month, interest on the notional amount of the contract.

b) the fed funds futures aren't the most reliable methodology for seeing exactly what is priced into the markets. the options on those contracts are better. fed funds futures options markets are what bloomberg uses to calculate the probability of a rate cut priced in by a certain time period. further, you can get a sense of the degree of certainty in those convictions by looking at the implied volatility of the contract. low implied vol intimates that certainty is high.the reverse holds true as well.

Barron

[CrushinFelt]

In January the Fed Funds market had things priced such that tehre was a 60% chance of the fed cutting rates by June. Eurodollars had something like a 30% chance. gogogo Eurodollar

[PairTheBoard]

[ QUOTE ]
[ QUOTE ]
I was just listening to the CNBC Bond expert. He was being questioned about the 4.5% yield on 2 year Treasuries. The question presented the theory that the 2 year yield should equate to what the average Fed Funds Rate will be over the next 2 years, thus indicating some major Fed rate cuts in the next 2 years. The Bond expert said, No. That's not right. What's really happening is the pricing in of Credit Risk on super short term debt, I assume like that which Money Market Funds hold.


[/ QUOTE ]

that assumption is incorrect. the credit risk pricing in doesn't affect MM asset riskiness, it relates to the fact that as credit markets experience large volaility and big negative jumps in spreads, people would rather hold risk free debt and pile into short term treasuries.

thus price of those bonds jump and, correspondingly, their yields fall.

Barron

[/ QUOTE ]

Which assumption? The CNBC bond expert was giving an opinion that the low yield on 2 year Treasuries indicates a pricing in of Risk for overnight type debt on a par with the Fed Funds rate. The only mention I made of an "assumption" was my assumption that he was essentially talking about Money Market funds. When you said the "assumption" was wrong, do you mean that he was not talking about Money Market funds? Or are you just disagreeing with his opinion?

If you are disagreeing with his opinion, then what are your reasons? As I pointed out in my post, merely making the observation that liquidity is parking in T-bills does not explain the situation. If the market has not repriced Risk on Money Market type funds, and it isn't pricing in Rate Cuts, then why isn't it safely parking liquidity at higher rates in Money Markets? Or if it's just irrationally out of whack and rushing into T-bills without regard to the fundamental factors of Rate Cuts and Risk on Money Market Funds, why isn't there an arbitrage opportunity, ie. go short on price of 2 year T-bills?

PairTheBoard

[DcifrThs]

[ QUOTE ]
[ QUOTE ]
[ QUOTE ]
I was just listening to the CNBC Bond expert. He was being questioned about the 4.5% yield on 2 year Treasuries. The question presented the theory that the 2 year yield should equate to what the average Fed Funds Rate will be over the next 2 years, thus indicating some major Fed rate cuts in the next 2 years. The Bond expert said, No. That's not right. What's really happening is the pricing in of Credit Risk on super short term debt, I assume like that which Money Market Funds hold.


[/ QUOTE ]

that assumption is incorrect. the credit risk pricing in doesn't affect MM asset riskiness, it relates to the fact that as credit markets experience large volaility and big negative jumps in spreads, people would rather hold risk free debt and pile into short term treasuries.

thus price of those bonds jump and, correspondingly, their yields fall.

Barron

[/ QUOTE ]

Which assumption? The CNBC bond expert was giving an opinion that the low yield on 2 year Treasuries indicates a pricing in of Risk for overnight type debt on a par with the Fed Funds rate. The only mention I made of an "assumption" was my assumption that he was essentially talking about Money Market funds. When you said the "assumption" was wrong, do you mean that he was not talking about Money Market funds? Or are you just disagreeing with his opinion?

If you are disagreeing with his opinion, then what are your reasons? As I pointed out in my post, merely making the observation that liquidity is parking in T-bills does not explain the situation. If the market has not repriced Risk on Money Market type funds, and it isn't pricing in Rate Cuts, then why isn't it safely parking liquidity at higher rates in Money Markets? Or if it's just irrationally out of whack and rushing into T-bills without regard to the fundamental factors of Rate Cuts and Risk on Money Market Funds, why isn't there an arbitrage opportunity, ie. go short on price of 2 year T-bills?

PairTheBoard

[/ QUOTE ]

i've bolded the assumption i was discussing.

2yr yields get the largest benefit (most demand) because of the reason you mentioned, that the price of rate cuts gets priced in on the part of the curve that it is most likely to happen.

you said a lot there and i don't know where to start with comments so if you'd like further comment, please ask questions 1 at a time and i'l ldo my best to provide my opinion.

i was simply saying that the pricing of money market funds comes from the providers of them (and isn't traded as far as i know...but i could be wrong), whereas the pricing of treasuries is directly visible from the market reaction.

what is the relationship between the US 2year yield and money market yields now? what about between eurodollar futures and money market yields now?

anyway, i don't think 2year yields reflect the CREDIT RISK of money market funds. thus THAT is the assumption i was refuting.

Barron

[Uglyowl]

The 4.5% yield is ballpark where the expected Fed Funds will average over the next two years. There is definately a downward bias on Fed Funds currently and quite a bit so.

[ QUOTE ]
anyway, i don't think 2year yields reflect the CREDIT RISK of money market funds. thus THAT is the assumption i was refuting.

[/ QUOTE ]

Theoretically the U.S. government is the safest lender in the world, they should be able to borrow (treasuries = U.S. gov't borrowings" than anyone else out there.

Anyother entity must pay a premium to this.

[CrushinFelt]

[ QUOTE ]
The question presented the theory that the 2 year yield should equate to what the average Fed Funds Rate will be over the next 2 years, thus indicating some major Fed rate cuts in the next 2 years.

[/ QUOTE ]

This theory also doesn't include supply/demand factors. Go to wikipedia and search for Yield Curve. Take a look at the different theories. The yield curve does different things for different reasons depending on what's going on in the market. This latest dip in the 2-year is likely a combination of preferred habitat and supply/demand... I think. I'm a lil' rusty.

[DcifrThs]

[ QUOTE ]
The 4.5% yield is ballpark where the expected Fed Funds will average over the next two years. There is definately a downward bias on Fed Funds currently and quite a bit so.

[ QUOTE ]
anyway, i don't think 2year yields reflect the CREDIT RISK of money market funds. thus THAT is the assumption i was refuting.

[/ QUOTE ]

Theoretically the U.S. government is the safest lender in the world, they should be able to borrow (treasuries = U.S. gov't borrowings" than anyone else out there.

Anyother entity must pay a premium to this.

[/ QUOTE ]

obviously.

thus 2 year risk free yeilds don't imply anything about the credit risk of banks offering money market funds.

and up to $100k, there is no risk (same US govt guarantee) so those deposits should yield at or extremely close to the risk free rate.

and i know there is no way the 4.5% 2 yr tnote yield is what the "average of the expected fed funds rate" will be over that time period.

it shows the expected MOVES of the target monetary policy rate, but no way is it the average rate over that period.

Barron