Thursday, April 30, 2009

Long Term Bond Yields and the Fed

The Federal Reserve is trying to hold down long term interest rates. The reason? To stimulate economic activity and encourage credit flow and especially mortgage lending. But, we have a problem. The Financial Times puts out headlines stating that “Rising bond yields present fresh challenge for the Fed.”

Long term bond rates have been rising lately. Yesterday, the 10-year Treasury hit 3.096%, a territory not breached since November 24, 2008. Last time I looked today, this yield was at 3.134%. The same was true for 20-year Treasuries topping 4.00% yesterday and today.

The Fed has been engaged in an effort to purchase longer term United States Treasury issues on a continuous basis as well as Federal Agency issues and mortgage-backed securities. It has made purchases in sizable amounts weekly. Now, the Fed seems to be losing its grip on yields in the long term end of the market.

The rationale given for this slippage? The record amounts of debt the United States government has to sell.

It is true that there are and will continue to be record amounts of debt issued by the United States government coming to the market now and for as far as we can see in the future. The supply issue may have some effect in the short run, but let me provide another possibility for the rise in rates in the longer term end of the yield curve.

The argument about whether or not the central bank can significantly impact yields in the longer term end of the yield curve has been going on for almost the entire length of my professional career. First, people think that the central bank can, and should, conduct open market operations so as to lower long term interest rates in order to spur on the economy. Then, research is produced that indicates that the Fed cannot achieve a significant reduction in long term yields through open market operations. A little later, some others think that it would be a good idea for the central bank to conduct open market operations to reduce long term interest rates. This is followed by another round of research indicating that the central bank cannot achieve this goal. Now, we are back at the point where policy makers believe that the Fed should attempt to keep long term interest rates low.

My reading of history is that the Federal Reserve cannot control, for any length of time, yields on long-term Treasury issues!

My reading of history also causes me to believe that the supply of Treasury securities cannot impact, for any length of time, the yields on long-term Treasury issues!

I am one that believes that long-term Treasury yields are determined by the appropriate expected real rate of interest and the expected rate of inflation. Since the expected real rate of interest does not change over short periods of time, the general movement in longer-terms interest rates will be determined by changes in expected inflation. And, expected inflation is dependent upon what the financial markets believe the Federal Reserve will be doing with respect to the monetization of the federal debt.

This, of course, has been a big fear in the financial markets. With all of the projected government debt coming down the road, many market participants believe that the Federal Reserve will have no choice but to monetize large portions of this debt. As more and more of the debt is monetized the probability that inflation will rise increases. And, this expectation gets built into long term interest rates.

If this is true, then the central bank faces a real dilemma. When the Federal Reserve attempts to keep long term interest rates low, it can cause a rise in inflationary expectations and this will create upward pressure on long term interest rates. If the Fed monetizes more of the debt to keep interest rates at the lower level, inflationary expectations will become even greater, putting even more upward pressure on long term interest rates. And, as long as the central bank continues to keep these long term yields below where the market wants them, the more damaging will be the consequences in the future.

In all my experience, I have not seen the Federal Reserve succeed in keeping long term interest rates below where the market wants them to be. I don’t expect them to succeed in their present efforts.

And, what about inflationary expectations? I believe that we can provide evidence from other markets that confirm this recent sensitivity to the increasing pressure on the monetary authorities to monetize the government debt. I am not concerned with the absolute levels of expected inflation, just the direction in which the spread has moved.

The spread between the 10-year government bond yield and the rate on 10-year inflation indexed government bonds is often used as an indicator of movements in inflationary expectations. The spread remained relatively constant from January 2009 through March. However, in April the spread has increased by 2 ½ times the January figure. This spread now is at a level we have not seen since early October 2008, right after the fall crisis hit. Market participants seem to be increasingly worried about what the Fed is going to have to do.

Furthermore, every time we see this spread increasing we tend to see a decline in the value of the United States dollar against the Euro and against other major currencies. Relative currency valuations are highly dependent upon changes in what central banks are expected to do because their actions can affect relative rates of inflation. If investors believe that the central bank in your country is going to monetize its government’s debt more rapidly than that of another country, the value of your currency will decline relative to that of the other country.

In this respect, the value of the United States dollar has declined over the past two days and tends to drop every time there is a rise in yields on longer term Treasury bonds. This would indicate that some of the same things affecting the yields on long term bonds are also affecting the value of the currency.

A final piece of evidence in support of this idea is that the market also responded to the minutes released yesterday by the Federal Reserve’s Open Market Committee. In those minutes the Fed stated that “the economic outlook has improved modestly since the March meeting…” It also noted that household spending “has shown signs of stabilizing while businesses have cut inventories, investments and staffing” implying that if consumer spending does stabilize or even increase, businesses will have to restock their shelves in order to support this spending which would be positive for economic recovery. Both of these statements foresee a stronger economy in the future, reinforcing the earlier fears of the market.

Long term Treasury yields were low because there was a flight to quality and because inflationary expectations were low. Unless there is another major shock to the system, I believe that the flight to quality is over and is in the process of being reversed. In addition, I believe that the Fed will continue to monetize the debt in increasing amounts for the Fed also emphasized in the minutes released yesterday that they will “stay the course” in the fight against an economic collapse. For both of these reasons, I feel that pressure will continue for long term Treasury yields to rise and for the value of the dollar to fall.

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