HOW DO T-BILL YIELDS GO NEGATIVE? BY THE APLIA ECONOMICS CONTENT TEAM

The week of September 15, 2008, was ripe with volatility in U.S. financial markets. Events unfolding in the wake of the mortgage crisis made investors extremely fearful. One result of this fear was a "flight to quality" as investors sought to avoid risk by moving their funds into the safest asset classes. U.S. Treasury securities (or "Treasuries," as they're commonly known) are one such asset class, considered to have virtually no risk.

An article from the Associated Press (Madlen Read, "Treasures Dip on RTC Speculation, but Anxiety High," September 18, 2008) discusses some of the factors that led investors to bid up the prices of 3-month United States Treasury bills (T-bills) to such an extent that their yields fell to a shockingly low level. Before 2008, the last time the T-bill yield was negative was 1940, in the early stages of World War II. According to the article:

Heavy buying of the 3-month Treasury bill, considered one of the safest investments around, sent its yield to just above zero at times during a fractious day across the financial markets. . . . When investors are fearful of taking risks, the economy suffers. Corporate credit spreads, or the difference between the yield on a corporate bond and a government bond, have been approaching levels not seen since World War II, noted Citigroup economist Steven Wieting in a note Thursday. That means it could be very expensive for companies to borrow money, which is essential to growing and maintaining a business if the credit markets don't thaw. . . . In other late Treasury trading, the benchmark 10-year Treasury note fell 28/32 to 103 29/32. Its yield rose to 3.53 percent from 3.42 percent late Wednesday, according to BGCantor Market Data. Yields move in the opposite direction from prices. . . . On Wednesday [September 17, 2008], demand for the 3-month Treasury bill had soared so high that the yield briefly dipped into negative territory, which means a bill holder would take a small loss at maturity. To many investors, a small loss is preferable to the massive declines seen this week on Wall Street.

So what events, in particular, caused this rush to T-bills? The following unsettling developments on Wall Street are claimed to be responsible for this freeze: the bankruptcy of Lehman Brothers Holdings Inc., the absorption of Merrill Lynch & Co. by Bank of America Corp., the $85 billion government bailout of the insurer American International Group Inc., and a money-market fund that had exposure to Lehman and failed to maintain assets of at least $1 for every dollar its clients invested.

Answer the following two questions.

Question 1: Explain the negative yield curve.

Question 2: Explain how the relationship between the bond market and the economy.