Is The Fed Losing The Interest Rate Battle?

I doubt that any of you have missed the news of the carnage in the bond markets. Yesterday the mortgage market took it on the chin and it spilled over to the market for Treasuries.

There is some speculation that the Fed’s program of quantitative easing is in for a rough ride, if not in fact doomed to failure in the sense that it is an attempt to lower interest rates. Others contend that the Fed doesn’t care so much about rates as they do simply about adding to the money supply and others believe that the market can accomodate a lot more issuance.

Here’s a quick synopsis of the various views.

John Jansen of Across the Curve writes:

Quantitative ease via purchase of Treasury securities by the central bank is an abject failure. Prior to the announcement of QE the 10 year note traded around 3 percent. It experienced a fleeting rally into the 2.40s and subsequently cratered and traded in the 3.70s yesterday.

A more pressing concern is the mortgage market which broke down yesterday and precipitated the rout elsewhere as portfolio managers who had believed in the efficacy of the Fed’s efforts and had eschewed hedging extension risk did so yesterday with a vengeance.

We have had a massive rout and as I mentioned in an earlier post the massive convexity selling we observed yesterday often signals that the trend is over for awhile. Those who had not hedged have done so and new players own bonds at new (cheap ) prices.

The problem which confronts market participants is that the market has shown itself to be bigger than the concerted action of the Federal Reserve. The Federal Reserve cannot command the market Canute like.

We may stabilize for awhile but the fundamentals of monetary policy and fiscal policy have not been addressed . Until America addresses those issues bond prices will remain under pressure.

At some point the market will force a serious discussion sharp cuts in entitlement spending or more interestingly tax increases to alleviate the problem.

You might also want to check out Yves Smith at Naked Capitalism. She has a long and rather good analysis that is pretty much in line with what Jansen postulates.

The insightful blog, Accrued Interest, has another take. The author doesn’t think the Fed cares so much about rates as they do about getting money into the economy.

Where does this leave us? With a bunch of problems I’m afraid. The massive decrease in money velocity has left us with a Alderaan-sized hole in the money supply. The Fed has already lowered the funds target to zero, so the only way to get more money into the system is to print it. Plain and simple.

The most efficient means to get printed money out into the world is to buy Treasury bonds. Not only does this put cash into the economy, but it also should lower borrowing yields and thus increase velocity.

When the Treasury buying program was announced, it was assumed that the Fed had some ceiling on Treasury yields in mind. This was a logical conclusion, since classically the Fed operates with a target, and buys or sells Fed Funds to meet that target. Why not do the same with the Treasury market? Target the 10-year at 3%?

But 3% came and went. 3.25% came and went. 3.5% came and went. The market kept waiting for the Fed to increase its purchases, but their purchase amounts have been remarkably consistent. Almost as though their only goal was to get money into the system, and they didn’t really care about where Treasury bonds actually traded.

Helicopter Ben is trying to do just that. Print money and pass it out. He’s just using the Treasury market as his helicopter. He’s not actually trying to push yields lower.

But the Accrued Interest article ends with what would appear to be an argument that the Fed needs to worry about the level of interest rates:

So I don’t know what the Fed’s next move is, but if interest rates stay where they are, those green shoots are going to turn to yellow. They need more water to start growing.

And then there’s Brad Setser’s Follow the Money. His reading is that demand for longer maturities from central banks has waned and been supplanted by private buyers and those buyers are demanding a higher yield. His contention is that the market can handle the new supply coming down the pike:

One aside: total Treasury issuance over the last 12 months of data was over $1.6 trillion. The market has already demonstrated that it can absorb a very large increase in supply. This was – obviously – a period of financial stress, which helped increase Treasury demand. It was also a period when the Fed was a net seller of Treasuries, not a net buyer. For most of 2008 the Fed was selling its Treasury stockpile to finance its lending to troubled financial institutions. It only started buying recently. That is one reason why it isn’t obvious to me that the total amount of Treasuries the private market will need to absorb over the next 12 months will be substantially higher than the amount it has absorbed over the last 12 months. However, the composition of new Treasury issuance is likely to continue to shift, so the amount of longer-term Treasuries the market will need to absorb will continue to rise. And of course a sustained deficits do produce a large rise in the outstanding stock …

I infer from his comments that the market can accommodate a lot of new supply but that it might have to pay a marginally higher rate. Based on the construction of his last sentence, I suppose he, like most of us, wouldn’t be at all shocked by things going much differently than we expect.

Now as I have been writing this post, the results of the seven year auction were announced and it went off well. Then again so did the other two auctions this week but that didn’t stop the market from cratering. I suppose the lesson there is not to read too much into the immediate results and watch what the market does afterwards.

I think that I come down pretty much in the John Jansen camp, though I’m not sure there is all that much difference in the opinions of these pundits. Central banks have historically failed miserably when they try and take on markets as large as the U.S. Treasury market. Initial successes inevitably have led to final capitulation as the markets seek their own level. I see no reason why this time should be any different.

Whether the Fed comes out and announces a target or doesn’t is probably somewhat meaningless. They know interest rates matter greatly to the recovery and certainly have an upper band beyond that they wouldn’t like to see breached. I’m just guessing but I suspect that we aren’t too far from that unannounced range. Low mortgage rates have breathed some life into the housing market and any sustained rise could choke it off. 

Where we go from here is up to the markets. That might not sit well with the technocrats who are convinced that recovery is simply a matter of pulling levers but it is the way things do work.


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