| The paper investigates the effect of the reduction of the supply of Treasury securities as a result of soaring budget surpluses in conjunction with the financial turmoil in October 1998 on U.S. fixed income markets. In particular, it focuses on the relationship among funding costs of commercial banks, Treasuries, and LIBORs over the period from January 1996 to August 2001 both in terms of levels of the rates and their volatilities. Regressions were used to establish the relationship among bank funding costs, Treasury yields, and LIBOR rates. Chow tests were performed to test for a structural change in these relationships during October 1998. Dummy variables were then added to the regressions to empirically compare the relative importance of LIBORs versus Treasuries in explaining the variation of bank funding costs during the post-October 1998 period.; The study concludes that the reduction of the supply of Treasury securities and the financial turmoil in October 1998 resulted in a significant shift in the U.S. fixed-income market structure. Specifically, bank funding costs, especially in the long term maturities, have shifted from being largely based on Treasuries to being based more on LIBORs since 1998. Moreover, the role of LIBORs as pricing benchmarks or hedging instruments in fixed income markets has increased over time relative to Treasuries.; The analysis is important because it shows that after October 1998 bank funding costs were less related to their Treasury yield benchmarks, and were linked more to LIBOR-based instruments. It also has implications for adequate modeling of the dynamics of bank funding costs. |
