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The spread between the two-year Treasury yield and a key interest rate set by the Federal Reserve is the narrowest since the depths of the coronavirus market liquidation, a potential sign of stress in the financial system.

The two-year Treasury yield, which closed at 0.115% on Tuesday, is 0.015 percentage points above the excess reserve interest rate, or IOER. It traded as low as 0.105% earlier in February. The Fed pays banks on reserves held in excess of those required by central bank regulatory policy as part of its efforts to maintain liquidity in the financial system.

When the coronavirus tipped markets and the plummeting economy in March, the Fed slashed the IOER by 1 percentage point to 0.10% – alongside other interventions – to consolidate loan markets. short term and support economic activity. The spread between the IOER and the two-year yield has generally been over 0.05 percentage point since the Fed cut the rate to its lowest level ever in March.

Traders said the narrowing of this spread reflects appetite for short-term debt as investors gobble up safe assets and park their cash. It also highlights a key point of tension in financial markets: to what extent is the Fed’s support to the markets pushing asset prices to unsustainable levels, and to what extent does that leave the markets bond and other areas exposed to sudden reversals.

Analysts looked at the results of Treasury auctions to assess whether an increase in budget spending and a surge in the supply of treasury bills would cause Treasury prices to fall in the short term and yield higher. So far, this has not happened. But bond traders fear inflation will rise in the months and years to come as the government prints money to support the economy and cover future borrowing costs.

Traders say short-term yields would be higher if the central bank did not anchor rates. The Fed has bought $ 80 billion in treasury bills every month since June and cut rates to almost zero in March to stabilize financial markets.

The idea is that low interest rates and bond purchases stimulate spending by providing cheap credit to businesses and households. Some bond investors fear that too much cheap credit will lead to inflation.

“What is usually the downside to something that looks perfect? Debt, ”said Kevin Walter, Co-Director of Global Treasury Bill Trading at Barclays. He notes that the Treasury issued more than $ 350 billion in debt in February, up from $ 197 billion a year ago.

The Federal Reserve cut the excess reserve interest rate to its lowest level ever last March.


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Traders say the Fed’s policy helps keep rates artificially lower, leaving treasury markets vulnerable to a sharp reversal once inflation rises again.

Yet inflation is below 2%, having only rarely exceeded this Fed target in recent years, and the labor market recovery remains weak. Unemployment in February was 6.3%, down from less than 4% since February last year and jobless claims – a proxy for layoffs – have remained above the pre-coronavirus peak.

Another corner of US markets is sending warning signals: The 10-year equilibrium rate, which tracks annual inflation expectations over the next decade, traded as high as 2.24% on the week last.

The benchmark 10-year US Treasury yield closed at 1.363% on Tuesday, according to Tradeweb – down slightly from Monday after Fed Chairman Jerome Powell reiterated the central bank remains committed to backing the economy with near zero interest rates and asset purchases until the economy has made “further substantial progress”.

The difference between the break-even rate and the Treasury yield has recently widened to more than a percentage point. For some, this is a sign that inflation is not far away and that financial markets remain vulnerable to bubbles.

“I would characterize the phase we are in now as an era of hyper-stimulation between fiscal and monetary policy,” said Thomas Pluta, global head of linear rate trading at JPMorgan Chase & Co. in assets like crypto, commodities and stocks even. (Traders on Reddit’s WallStreetBets forum use memes like a rocket emoji to accompany favorite stock picks like GameStop Corp.)

Write to Julia-Ambra Verlaine at Julia.Verlaine@wsj.com

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