Short-term rates remain range-bound as the Federal Reserve balances the dual challenge of below-trend economic growth and above-target inflation. The domestic private economy is in recession as weak growth in real disposable income for consumers and lowered profits for non-financial companies dictate a lack of spending power. Meanwhile, inflation continues to exceed the top end of the Fed's perceived preference range for inflation. Add to all that the uncertainty of credit quality and you have a prescription for unchanged rates at the short end.
Long-Term Rates: Risk Dictates a Bigger Range of Outcomes
However, at the long end of the curve, rates are expected to drift upward as concerns on three fronts - inflation, the dollar, and greater Treasury financing needs - are likely to push benchmark Treasury rates above four percent in the months ahead. Inflation expectations have already moved upward while estimates of Treasury financing needs have likewise risen.
Credit Spreads: In Search of Normality
Credit spreads are not expected to narrow much more as event risk remains a concern for investors. Capital markets continue to search for a new risk/reward tradeoff. At present, the trend in the TED spread (three month futures contract for U.S. Treasuries less the three month Eurodollar futures contract) suggests the new equilibrium spread will remain higher than where it had been during the 2004-2006 period. Risk is being priced back into the fixed income market, but the market is still determining what the new normal equilibrium price will be.
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