The Federal Reserve’s unorthodox policy response since the emergence of the credit crisis 19 months ago continues to bear fruit as credit spreads narrow. Though these and other measures are working to instill investor confidence, other important areas of the credit market remain hostage to illiquidity and historically high credit spreads that have failed to meaningfully narrow.

The Fed has aggressively engaged several segments of the once clogged credit system, including long-term mortgage agency debt and commercial paper. The central bank’s balance sheet expanded by $1.3 trillion dollars to $2.2 trillion dollars since August as the Fed purchased everything from corporate commercial paper to bonds backed by consumer payments on mortgages and car loans.



Some important short-term credit markets are definitely improving, including tightening credit spreads. These include LIBOR (London Inter-bank Offered Rate) and the TED Spread, or the difference between 90-day LIBOR and 90-day Treasury bills.

Another positive development since January is the widening yield curve, or the difference between two-year and ten-year Treasury bond yields. A widening yield curve portends to growing market expectations that economic growth is expanding thereby driving interest rates higher. In the first quarter, U.S. Treasury bonds suffered their worst three-month period since 2004.

Credit markets overall have rallied sharply since early March as stocks bottomed.

In addition to tighter or lower credit spreads across the entire spectrum of fixed-income benchmarks, corporate bond issuance has surged since January, including several deals for junk bonds, or high-yield debt.

Yet other problems linger on the Fed’s attack menu confirming the central banks’ limits on soothing or healing all fractured credit markets.

Despite lower credit spreads since March, the entire gamut of investment grade and speculative grade credit spreads remain historically elevated. Financing or refinancing for most companies remains difficult at best and even the most credit-worthy customers are paying historically high premiums above prime rates to secure funding. The credit crisis is indeed easing but by no means has it ended.

The only spreads that have returned somewhat close to pre-August 2007 levels is the 30-year mortgage rate area as the Fed has purchased more than $350 billion dollars of mortgage agency debt since last November. The bad news is that the Fed has started a chain of dependency whereby important segments of credit have grown accustomed to Fed or government purchases; once these operations cease it’s possible the market will force interest rates higher.

The Federal Reserve and Treasury have also started to monetize Treasury debt through a process called “quantitative easing” while also helping bruised states and municipalities through financial aid; the government now offers to pay up to a third of the interest or debt servicing for those states seeking government assistance or bailouts.

The Fed has done a good job helping to influence short-term credit markets and has injected desperate liquidity to clogged areas of borrowing and corporate financing.

Yet these bold initiatives alone won’t cure the credit crisis because too many other areas of the marketplace remain squeezed, including traditional sources of long-term lending to consumers (credit card), commercial and industrial real estate loans and auto loans. Default rates for these segments of busted credit are now at their highest levels in years and likely to get worse as unemployment continues to soar.

The war is being won at the short end of the borrowing curve but remains an ongoing battle at the long end of the marketplace, which is much more difficult for the government to control.