Flattening of the Yield Curve Reflects Expectation of Rate Cut

An inverted yield curve is usually a danger signal for banks and the economy at large, but experts aren't especially worried about the recent flattening of the curve.

The yield on six-month and one-year Treasury securities has dipped below the yield on three-month securities, they say, simply because traders are betting on another cut in interest rates by the Federal Reserve - and fairly soon.

The stock market rally that usually accompanies expectations of a rate cut is nowhere to be seen, as equity investors worry about the federal budget impasse.

But the expectation that the Fed will act, possibly at its Jan. 31 meeting, is clearly signaled in the bond market, said David Pierce Jones, a managing director and head of fixed-income products with Credit Suisse Financial Products, a derivatives unit of CS Holding Group.

In the past, higher yields on short-term securities than on longer-term substitutes has been seen as an early warning that investors and traders are expecting a recession.

And because banks borrow short term to lend over a longer period, an inverted yield curve combines to hurt spreads by creating higher-cost borrowings and lower-yielding loans.

But Carole Berger, a regional bank analyst at Salomon Brothers Inc., said banks are better prepared today for a yield curve inversion than they have been in the past.

"One thing that banks have been particularly good at this cycle which helps mitigate that risk is that they kept the spread between prime and fed funds incredibly stable these last two years," she said.

She said banks have maintained a steady 300-basis-point spread between the two rates over this period.

"Unless you get a very steep inverted curve, I don't think it would be too detrimental to the fundamentals, though it would clearly worry people."

Rates quoted on the Eurodollar futures contract at the Chicago Mercantile Exchange, which are used as a basis for many interest rate swaps transactions, indicate a similar flattening.

In trading last Friday, rates on that contract, which is based on the London interbank offered rate, were at 5.35% for March, compared with the 5.60% rate quoted for Libor in the spot market. Rates for contracts expiring in June and September fell even further, to 5.05% and 4.97%, respectively.

Ms. Berger said the current inversion in the swaps market, which is based on prices in the futures markets, does not suggest a recession is on the way. Instead, she said, aberrations in the futures markets, such as the current situation, often reflect the specific circumstances of companies in the market.

"Generally I don't worry about the futures market," said Ms. Berger. "If you go back historically and look at the futures market and what rates are six, nine, or 12 months later, it's almost never correct."

But a derivatives trader at a large dealer bank said the speed at which the cuts are made could have implications for institutions with large mortgage servicing operations.

"If you think that interest rates are going to come down quickly, the people begin to worry about prepayments," the trader said.

While mortgage servicers have typically attempted to hedge against such problems by purchasing swaps contracts with interest rate floors built in, he said that is not the case currently.

"We haven't seen a lot of mortgage servicer flow yet," he said.

While inversions in the swaps market rarely portend similar interest rate patterns in other markets, the situation could cause problems if it is repeated in the spot market.

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