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How Does the Fed Funds Rate Affect Treasury Bills?

Second, demand for Treasury bills is much more rigid than demand for notes and bonds. Treasury bills are the quintessential risk-free asset. Like all Treasury securities, they are free of credit risk. And as short-term instruments, they also are free of interest rate risk. Investors who want a totally risk-free asset -- or institutional investors that have internal requirements regarding totally risk-free assets -- have no choice but to buy Treasury bills.

"Treasury bill yields in general tend to be artificially low because a few accounts will sacrifice a good deal of yield for a legally risk-free instrument," Wrightsom & Associates chief economist Lou Crandall explains.

In other words, the mechanism that keeps Treasury note and bond yields from dropping too low -- people will resist buying them -- isn't present to the same degree in the bill market. Accordingly, a shortage of bills can cause their yields to drop sharply, regardless of where the fed funds rate stands.

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