Y2K Shakes Up the Money Markets but Leaves Treasuries Alone

The Treasury market has struggled this year for reasons unrelated to Y2K worries, but there's a big Y2K play going on in the money markets.
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If you have some spare cash that you're willing to lend to the banking system over the turn of the year, there's a little bit of money to be made.

Apart from that, though, there's little if any clear evidence in the fixed-income markets that anyone expects much unpleasantness -- financial or otherwise -- as a result of the Y2K date change.

Sure, the bond markets have had a terrible time this year. It's shaping up to be the worst year the bond market has experienced since 1994, when the

Fed

hiked interest rates seven times and the benchmark

Lehman Aggregate Index

lost 2.92% -- the index's worst year ever. So far this year, the Lehman Aggregate Index is off 0.96%.

Both Treasury and corporate issues have lost ground. The

Lehman Treasury Index

is off 3.25%, while the

Lehman Corporate Index

is off 2.32%. But it's tough to argue that Y2K is clearly responsible.

Y2K Effect Screams in Money Markets

The only place in the fixed-income markets where a Y2K effect is clearly apparent -- and it's screamingly apparent -- is in the money markets. Because it is assumed that everyone with cash in the bank will want to withdraw a big fat wad of it by New Year's Eve (the Fed is figuring on an extra $500 for each of the country's 100 million households), banks are paying up for deposits that don't mature until after the turn.

The shift occurred very suddenly at the end of September, when benchmark three-month interest rates such as Libor (the London Interbank Offered Rate), the eurodollar deposit rate (the interest rate paid on dollars on deposit overseas) and the bank CD rate began to cover a period that stretches into next year. As the charts below show, on Sept. 29, three-month Libor shot up to 6.08% from 5.51% the day before, three-month eurodollar deposits went from 5.35% to 5.96% and three-month CD rates rose to 6.02% from 5.45%. Similarly, on Thursday, two-month interest rates rose sharply.

3-Month CD

Source: Reuters

3-Month Libor

Source: Reuters

3-Month Eurodollar

Source: Reuters

As a result, the yield curves for those instruments developed Y2K humps, as these charts show.

Libor Curve

Source: Reuters

Eurodollar Curve

Source: Reuters

But analysts say this has more to do with banks' unusual degree of insensitivity to the cost of money over the turn of the century than with genuine concern among depositors that banks won't be able to repay them early in the new year.

"There's definitely risk aversion, but it's not on the part of buyers" of interest-rate products, says

Wrightson Associates

chief economist Lou Crandall. "It's the risk of being left out when the musical-chairs game comes to an end on the part of sellers. The premiums being paid in the money markets over the turn are not because of fear that any banks are going to go under or because lenders are unwilling to give them money, but because banks are determined to lock up funding early. Over Y2K, finding the cheapest rate is not necessarily the most important thing."

Inflation, Not Y2K, Weighing on Treasuries

One certainly can't blame the Treasury market's troubles on Y2K, because Treasuries are the safest, most liquid financial assets to be had. "Concerns about the economy being adversely affected would be a plus for the

Treasury market," says

Barclays Capital

senior economist Henry Willmore. Rather, Treasuries have been sacked by the upturn in inflation and the Fed's response to it. So far, the Fed has reversed two of the three rate cuts it administered last fall.

For a couple of weeks after the Treasury's last quarterly refunding auction, in August, demand for the issues that will be the newest and therefore most liquid at year-end strengthened, but even that effect has worn off. The August refunding included the last new 30-year bond that will be issued this year, and traders said that was why its yield rallied sharply relative to the August 10-year note, which will be replaced by a new 10-year note at the fourth-quarter refunding this month. The yield difference between the bond and the 10-year note fell to about 30 at the end of August from about 50 basis points in mid-August. It has since rebounded to about 40 basis points, the lower end of its recent range.

As for the corporate debt market (including federal agency, mortgage-backed, asset-backed and high-yield issues), its troubles this year are attributable to Y2K -- but not in the way the casual observer might assume, analysts say.

Risky bond yields rose sharply relative to Treasury yields this year -- a phenomenon perhaps most clearly illustrated by swap spreads. (See chart below.) A swap spread is nothing more than the increment over a Treasury yield that the payer of a fixed interest rate has to pay to arrange an interest-rate swap in which he will receive a floating interest rate -- typically Libor -- over a certain period. Widening swap spreads generally indicate rising concern about credit quality, since both parties to an interest-rate swap take on the risk that their counterparty will fail to uphold the agreement.

Swap Ya Fixed for Floating?
Higher premiums on the fixed leg of a 10-year interest rate swap reflect rising concern about credit -- or perhaps not.

Source: Reuters

It's impossible to know for sure why swap and credit spreads widened this year, but some analysts say it had less to do with investor unwillingness to lend money to less-than-sterling borrowers than with an unrelenting crush by the borrowers to get enough cash, fast, to sustain them over year-end. According to

Thomson Financial Securities Data

, investment-grade corporate bond issuance during the February-to-April period, totaling $162.8 billion, was $8.9 billion heavier than the heaviest three-month period last year.

Corporate bond issuance exploded in the first five months of the year as corporate treasurers hurried to market and sold bonds to investors without balking at rising interest rates, as they normally would. "We saw corporate rates move out at the outset of the third quarter, but it turns out to be not so much because of perceived credit risk on the demand side as a lack of interest-rate sensitivity on the supply side," Crandall. "Corporate treasurers ignored small shifts in costs. They wanted to get their financing done wherever the market was."

As an explanation, it pairs nicely with the observation (however obvious) that there has been no flight to the safety and liquidity of Treasuries this year.

It's also important to remember when evaluating the performance of corporate bonds this year that last year's massive losses in this arena have made dealers much less willing to commit capital to the sector, points out Jim Bianco, president of

Bianco Research

in Barrington, Ill.