Thursday, August 21, 2008

Tracking Fed Sentiment With Short-Term Treasury Yields

One gauge of Fed sentiment are the yields on short-term Treasury bills and notes. These are sensitive to anticipated Fed easing and tightening, providing a way of assessing whether the Fed is more sensitive to recession (and thus needs to ease rates) or whether the Fed is more sensitive to inflation (and thus needs to hike rates).

Above we see a chart of 2-year Treasury Note yields vs. the Dow Jones Industrial Average for 2008. We saw aggressive Fed easing early in the year as stocks moved to lows on the heels of banking problems. Indeed, the Fed Funds rate moved from about 4.25% in January to under 3% in March.

The Fed Funds rate has remained at 2% since May, but 2-year Treasury yields have crept up to over 2.5% since that time--even as the Dow has moved to new lows and the GSEs (FNM and FRE) have been in a tailspin. As bad as the economy looks, in the face of inflation, markets are not expecting any quantitative easing from the Fed.