Mojo Rsing

This week the Treasury will reopen its current 3-year and 10-year notes along with its 30-year bond. With the economy stabilizing (albeit at below trend level) and our foreign trading partners (China) managing their currencies to reflect a desire to slow down their domestic economies and a willingness of hereto for risk averse investors to seek out higher returns the demand for longer dated treasuries could be softer this time around. This could cause the yield curve to steepen in the near term

Although the yield curve may steepen in the near term, I would caution against worrying that long-term rates are going run dramatically higher. Appetite for long-term treasuries may lighten, but indirect bidders (which include central banks) are not going on a U.S. treasury hunger strike.

One fear out in the markets is the question of how will rates be affected when the Fed sells it huge position in U.S. treasuries. Why sell when the Fed can borrow money from market participants, using its treasury positions as collateral. This has two benefits. It removes money from the system (the Fed is borrowing money) thereby tightening monetary policy without raising the Fed Funds rate and it also keeps long-term rates from rising sharply buy not dumping U.S. treasuries into the market. Instead, these treasury securities will be held by counterparties as collateral. In return, the Fed's counterparties will earn a money market-type rate for engaging in the the transaction. Such a transaction is known as a repurchase agreement or "repo".

Until now, Fed repos have usually occurred between the Fed and primary dealers of U.S. treasuries. However this time, the fed is permitting money market funds to engage in repurchase agreements with the Fed. To accomplish this, a money market fund will lend money to the Fed, receive interest paid by the Fed at an overnight rate and will receive U.S. treasuries and agency paper as collateral. A money market fund could lend the Fed $10 million, get paid 1.00% on its money and hold 10-year notes or long bonds as collateral. By permitting money market funds participate in Fed repos, possible homes for long-dated treasuries are increased.

Investors tend to become myopically focused on Fed Fund rates, amount of debt issued, deficits, etc. Although all of the aforementioned factors are important, the Fed has many more arrows in its quiver to keep rates under control and moderate (but not eliminate) their rise. Look for long-term rates to rise modestly and moderately, but for short-term rates to remain stubbornly low. Not good for already rich LIBOR floating rate preferreds and bonds.