The Treasury market has undergone dramatic changes since last February. An aggressive easing policy by the Federal Reserve led Treasury yields on a downward track in 2001, but the Fed cuts were nothing compared with the dramatic rally that ensued in the wake of September 11. On the supply side, the Treasury introduced a new weekly bill, a four-week bill, and announced an indefinite suspension for new 30-year bonds. While many investors had long expected such supply changes, the market was still caught by surprise at the November refunding announcement. Treasuries have yet to find stable ground, dropping as stocks began to rally in December. January has seen Treasury securities rally once again as market players continue to hope for further rate cuts and a later-than-sooner recovery for the economy and stock market.

Eliminations
One major change in the Treasury securities market was the elimination of the 30-year bond, which has suffered from lack of liquidity and the loss of its benchmark status over the past two years. As the 10-year note grew in status to become the benchmark security for the fixed-income sector, market players decreased their positions on the 30-year bond. Ever since the Bond Market Association recommended its elimination last February, the 30-year bond has traded poorly with little interest. While it did get a boost after the September 11th disaster brought investors pouring into the bond market, there was still not enough interest in this security. The last 30-year note auction was held on August 9, 2001.

From the late 1970s, the United States had been the only major country to offer 30-year government securities. Other key nations offer 10-year securities as their longest-term maturity. The United States has now become one of the pack.

Issue-by-issue update
Despite the end of the line for the 30-year bond, market demand for other issues has increased in the past year as the risk-free fixed-income market has for the most part shown a higher rate of return than the stock market. It should be noted that the falling yields noted below are a healthy sign for fixed-income securities.

The 3-month bill yield in the chart above decreased with the ailing economy but fell drastically in September and has continued falling amid Fed interest rate cuts. At mid-year the U.S. Treasury, in an effort to combat poor bond-market liquidity, began auctioning off a greater quantity of 3-month bills per week.

The 6-month bill, featured above, shows the same trend as the 3-month bill. It, too, has seen its yield reduced since the September 11th attacks. The yield on this security, as well as the 3-month, has been at or near lows never seen before. Of course, we haven't seen the federal funds rate target at such a low level (1.75 percent) in 40 years. Three- and 6-month bill yields tend to move in tandem with the Fed funds rate.

The U.S. Treasury also added the 4-week bill to the weekly auction schedule (chart above). Market players have remained content with this weekly issuance, although supply has been diminishing in recent weeks. Demand has remained fairly consistent for this new security. The Treasury introduced the four-week bill to reduce uncertainty surrounding short-term borrowing, a problem with the prior policy of offering cash management bills on a sporadic basis. This allows greater consistency and less uncertainty in the market.

The above chart shows the yield on the 2-year note, again showing the same trend as the 3- and 6-month bills. The 2-year note is often viewed as a leading indicator of changes in Fed policy. When the yield on this note falls below the federal funds rate, it indicates that market players expect the Fed to cut rates. Conversely, when the 2-year note is rising rapidly above the federal funds rate, it signals expectations of Fed rate hikes. The recent rise in yield for this security may signal the end of the Fed easing cycle.

Monthly auctions of the 2-year, in contrast to the weekly auctions for 3- and 6-month bills, add volatility to demand for the note, as would further reductions in its supply. Amounts auctioned were on the decline last year before lack of market liquidity forced the Treasury to increase offerings in the security. December's 2-year note auction saw a record $23.0 billion offered by the Treasury, while January's auction will be even higher, at $25.0 billion.

The 5-year note, sometimes known as the "poor man's" note in the bond market for its sporadic issuance, has likewise moved with the changing market, and amounts at the Treasury's November refunding announcement were also increased to cover liquidity concerns.

The above 10-year note, the "benchmark" U.S. security, has followed the market trend, with its yield falling back towards 1998 levels. The U.S. Treasury has adjusted supply of this issue at its twice-yearly refunding dates. Auction amounts of the 10-year note averaged $9.25 billion during the 2001 refundings, up slightly from the $9 billion average of 2000. Demand has been healthy for the security, although the last refunding of 2001 saw a reduced amount of $6.0 billion auctioned off.

Update on Buybacks
The U.S. Treasury is continuing buybacks on the public debt, although the Bush Administration has not made eliminating debt a priority. Most economists agree that the elimination of public debt is important, but the Treasury has followed a very gradual approach to buybacks, especially in the wake of September 11. With market players buying up risk-free Treasury securities following the attacks, supply became a real issue. The Treasury market became quite illiquid after the initial run on securities, forcing the Treasury to think twice about eliminating debt during a time of high demand.

The Congressional and Senate Budget Office figures are now showing deficits for the next few years. Treasury officials are holding off on declaring a buyback schedule, and will only do so if it becomes necessary. While the stimulative tax cut may have kept consumers purchasing during a recessionary period, it also dried up much of the past surpluses. Proponents of eliminating the debt, such as Fed Chairman Alan Greenspan, have become less vocal as the prospects of deficits build. If the U.S. economy begins to grow in the coming year, many economists and market players would like to see President Bush and the Treasury Department make buybacks a priority once again.

The Bottom Line
Where does this leave the individual investor? Treasury securities have become a more attractive investment as the yield curve has fallen and the stock market has been fighting off weakness for nearly two years. Risk-free investments are attractive during times of economic weakness, likely increasing demand for Treasury securities ahead. Should investors prefer to pick up yield, they would have to increase their risk profile and head towards other fixed income instruments such as corporate bonds. Yet for now, the Treasury market is a mixed bet for investors, as a possible recovery for the stock market would trigger an adverse reaction in the fixed-income markets.

Damir Fonovich, Market Analyst, Econoday