More Will They or Won’t They or When Will They, by Tim Duy: Thursday’s action in the Treasury market – which saw the yield on the 10-year bond leap 18 basis points – has triggered another debate of when will the Fed begin wholesale purchase of Treasuries to hold yields close to zero and openly expand the monetary base. John Jansen thinks it is only a matter of time:
One trader noted, and I concur, that traders are now engaged in a game of financial chicken with Federal Reserve as traders attempt to force the Fed’s hand. The Fed has no desire for higher rates and the higher rates defeats the intent of the myriad of plans it has implemented to fight the financial crisis. I do not know what level on 5 year or 10 year notes would invite Federal Reserve coupon purchases. However, in this fragile environment such a level does exist and I think that the street will now probe to discern that level.
The Federal Reserve has purchased several hundred billion mortgages and is significantly underwater for all its efforts. They have bought big chunks of FNMA 4s between 100 and 101. Those bonds currently trade around 99.
I mentioned in the preceding post that I thought that the street would force the Fed’s hand regarding purchases of Treasuries. The debacle in the Treasury market has erased the gains in the mortgage market. The Fed will not wait long to buy Treasuries as dilatory action will only lead to higher mortgage rates.
Earlier I wrote that the Fed’s last statement, however, appears to say that the Fed is not yet targeting the level of long rates. Instead, the Fed, using the asset side approach to balance sheet policy, is only interested in outright Treasury purchases if deemed supportive of maintaining normal credit market functioning. On this point, CR revives his series on credit crisis indicators, and concludes that we have already seen significant improvement. Moreover, his chart of the yields on the 10-year Treasury reminds us that Treasuries remain at historically LOW levels, and could rise quite a bit and still be “low.” Another sign of normality:
The difference between 10-year Treasury Inflation Protected Securities and nominal Treasuries rose to one percent for the first time in more than three months as traders brace for government-induced inflation.
As markets heal, we would expect investors to move out of low-yield risk-free assets and into other, higher yielding assets, thereby improving yield spreads. A rise in the 10-year Treasury back to 4%, in such an environment, should be seen as a welcome indication of improving financial health. But that might entail rate increases in some consumer loans as well, including all important mortgages. Therein lays the conundrum – if markets conditions normalize, will the Fed breath sigh of relief, pat themselves on the back, and walk away? Or will Fed Chairman Ben Bernanke climb aboard his helicopter?
Moreover, we have been working on the assumption that governments around the world can turn the fiscal faucets on full blast because there are endless amounts of excess saving that can be sucked up and put to productive use. I would not throw away that story just yet; I think in a normalizing financial environment rates could back up to 4% without cause for alarm. But the US government alone is asking markets to absorb an ever rising amount of debt. And the US still runs a current account deficit, meaning we still need external financing resources. So I would not be surprised to see rates start to rise; I have said before that the key to getting fiscal stimulus right is listening to the market signals; if rates start moving steadily upward beyond 4%, authorities should carefully consider the possibility that they have gone overboard.
If rates are rising simply due to financial healing or obvious strains on the capacity of the debt markets to absorb endless trillions of US debt (which, by the way, would be something of a surprise given the steady willingness to absorb seemingly endless debt since the Reagan Administration), the room for policy error is great. If the Federal Reserve chooses to lean against the market and start effectively monetizing fiscal spending, I think we could all agree that we would be moving into an inflationary environment. Sell the Dollar, buy commodities. On the upside, some serious inflation would reduce the debt overhang in real terms.
Note that I am not saying we are at this point; it is just one risk in a range of possibilities. A fresh bout of financial fever could send rates back toward the 2% mark, and that would end this story entirely.
In short, the Fed opened something of a can of worms by offering up Treasury purchases as an option in the monetary policy arsenal – they left open the question of what would trigger them to use that weapon. Only if necessary for the smooth functioning of financial markets? Or to hold rates artificially low? By my read, the most recent statement suggests the former. But I will also be the first to admit that Bernanke has tended to error on the side of more policy is better.