Financial markets returned to risk aversion mode yesterday, truncating the relief that followed the US Treasury's rescue of Fannie Mae and Freddie Mac.
After big falls in Asian equities, US and European stock markets came under mounting pressure following Monday's solid rally. Problems in the US housing market and the ultimate cost of the credit squeeze are at the forefront of investors' minds.
Financials were lower, with the sector still facing considerable headwind from the credit crunch. Shares in Lehman Brothers plunged below $10 as uncertainty surrounded the investment bank's efforts to raise capital and dispose of assets.
As equities stumbled and risk aversion intensified, Treasury yields fell. After rising to 3.72 per cent in early trade, the yield on the 10-year note was below 3.60 per cent. That represents a sharp reversal from a high of 3.85 per cent on Monday, when the rescue prompted a brief sell-off. By backstopping debt issued by the two government-sponsored enterprises (GSEs), the US Treasury has reassured investors, including foreign institutions and central banks.
On Monday the news sparked a narrowing of some 30 basis points in the so-called agency spread, the difference between the yields on GSE bonds and Treasuries. But near lunchtime in New York yesterday the market was four basis points wider.
That leaves the 10-year agency spread well above the 30-45 basis point range that sufficed before worries about the GSEs surfaced.
"Agency spreads are still historically wide and it is disappointing that [they] have not come in more, given that the US government is now backing the market," said Alan Ruskin, strategist at RBS Greenwich Capital. "There is still a wariness about holding Fannie's and Freddie's paper."
Mortgage rates fell further, but by lunchtime in New York the move was losing traction. An index of Fannie Mae's 30-year current coupon touched a low of 5.07 per cent before it retreated to 5.18 per cent.
The index closed at 5.21 per cent on Monday, down from 5.63 per cent at the end of last week.
Lower mortgage rates should translate into cheaper borrowing costs for homeowners over time, but the real challenge for the Treasury is whether investors will continue buying mortgages.
Dominic Konstam, head of interest rate strategy at Credit Suisse, said any reticence among investors in the coming weeks would complicate matters for the Treasury.
"If we don't see continued buying of mortgages then the worries about the public sector becoming very entrenched in the market, leading to greater issuance of Treasuries, will gather pace."
While it is uncertain how much the GSE rescue will ultimately cost taxpayers, many in the Treasury market worry that yields will eventually rise as issuance grows from the higher budget deficits being forecast by the Congressional Budget Office.
The CBO said yesterday it would incorporate most of the $1,700bn (€1,200bn, £966bn) in debt held by the GSEs and the $3,500bn of outstanding mortgages they guarantee as federal -obligations.
"People have a queasy feeling that the bill could grow over time," said Mr Ruskin. "It is hard to make a judgment as to the ultimate price tag for the bail-out."
