Date: Thursday, June 30, 2005
Is a questioning term that has been applied to the credit markets after repeated increases in the Fed Funds rate.
In particular, this conundrum questions why short-term rates have gone up yet long-term rates have declined.
Perhaps, a simple explanation accounts for a big piece of the answer. If we step back a bit, we notice that many banks, hedge funds and other institutional players have previously positioned "carry trades" to gain profits. In other words, they financed higher yielding instruments with lower cost funds from the
nearby end of the yield curve. The previously steep positive yield curve was conducive to this sort of trading strategy.
Since then the Federal Reserve by its words and deeds has telegraphed that it wants interest rates to go higher. To this objective it has focused on the nearby section of the credit market.
Given this behavior by the Central Bank, traders can now implement, at the minimum, simple trades to try to benefit from the changing slope of the yield curve. Particularly, they can sell the nearby maturities and buy the deferred months. This activity unwinds or even reverse the previous positions. Effectively, this puts downward pricing pressure on short-term instruments (prices down, yields up) while the other leg of the flattening trade requires longer-term maturity purchases that bouy thoses prices (lowers those interest rates).
Notes: In general, for fixed rate securities, prices and yields move inversely. Also, short-term rates tend to be more volatile in yield while longer term rates more vulnerable on price.
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