The credit crisis eases, but watch long-term bond yields

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The government may be slowly fixing one credit crunch -- and creating another.

There were tentative signs of improvement on Tuesday in short-term credit markets, after the huge new steps U.S. and European policymakers announced over the weekend to bolster the global banking system.

Some key measures of bank funding costs declined. The London interbank offered rate (Libor) for one-month dollar loans slipped to 4.47% from 4.56% on Monday. It was the second straight drop, and the first two-day easing since late August.

There also were indications of better investor demand in the commercial paper market, where companies issue short-term IOUs. And California saw robust pre-ordering from individual investors for its sale Thursday of seven- and eight-month notes.

But long-term Treasury bond yields rose sharply, lifting the 10-year T-note yield 0.21 of a point to 4.08% -- the highest since July 25. And long-term municipal bond yields soared; a Bloomberg News index of tax-free yields on 30-year California general obligation bonds jumped to 5.84%, up from 5.69% on Friday and 5% in mid-September.

Bond traders say the market is beginning to focus intently on the heavy borrowing the Treasury will have to do to finance its $700-billion bailout of the banking system.

‘There’s a huge supply of bonds coming,’ said Ray Remy, head of fixed income at Daiwa Securities in New York. ‘That money has to get raised.’

That is making investors less interested in buying longer-term Treasury securities now, figuring yields will only rise, he said.

It also could be that some investors are selling Treasuries to invest in riskier securities, as worries about a financial-system meltdown recede. And although rising Treasury yields normally would push up yields on corporate bonds, the latter already have rocketed so high that a rebound in Treasury rates may not have much effect for the time being.

Still, some analysts say the jump in longer-term Treasury yields is worrisome, because it has been accompanied by a drop-off in demand for those securities from overseas.

‘There has been a real diminishing of demand from foreign investors over the last few months,’ said Tom Tucci, head Treasuries trader at RBC Capital Markets in New York. ‘We’ve seen them pulling back.’

One number on Tuesday was a reminder of the long-running U.S. reliance on foreign capital: The government said the budget deficit for fiscal 2008 (ended Sept. 30) was a record $455 billion. The latest deficit may not rival those of the Reagan years as a percentage of gross domestic product, but it’s still a drain on the world’s savings.

The risk is that foreign investors could further lose their appetite for Treasuries at current yields. With massive government borrowing in the pipeline, yields could have nowhere to go but up -- which also could push up mortgage rates, because they take their cue from Treasuries.