The Fed has a mess on its hands.
Yields on ten and thirty year Treasuries have shot up in the last few days as investors have become fixated on burgeoning Treasury supply in coming months and years. and, as belief in the “green shoots” story is rising, a shift to riskier assets. In addition, while the Chinese are still buying Treasuries (that is, they are still pegging their currency, determined to hold on to exports), they have shifted to the shorter end of the yield curve (and their past harrumphing about the dollar and Uncle Sam not stiffing them is probably on a delayed basis weighing on nervous investors). The yield curve is the steepest it has ever been.
The dealer community is also apparently very long Treasury bonds, so the losses they are taking now will be an offset to the “banks are earning their way out of this mess” picture.
The move up in yields isn’t simply a problem for companies that might have wanted to raise longer-term funding in the newly optimistic environment; it’s a huge spanner in the works for the Fed’s efforts to keep mortgage rates artificially low. Recall that while the Fed has been intervening in the markets, it has gone to great lengths to stress that it not doing quantitative easing, but influencing spreads. But with the long bond at 4.65%,, it can’t keep yields on mortgages as low as it wants them to be (not much north of 5%).
I had trouble with the logic of manipulating mortgage rates. Last week, in Washington, I mentioned that this keeping mortgages cheap would end in tears. What happens when the Fed succeeds in creating real inflation? A real market yield for mortgages will be, say, 6.5%, if not higher. And who will eat the losses on the 5% ish mortgages that are now under water? Hhhm, banks, pension funds, and insurance companies, who happen to be the same people who somehow cannot be permitted to take losses on bank bonds that would result from realistic pricing of bank assets.
Mortgage investors seem to have woken up to their risks. As John Jansen said Wednesday:
One trader in a note reports that conventional wisdom held that FNMA 4s would not trade appreciably below dollar price 99-16. That issue as of his writing was trading at 97-23 and he is comparing the carnage to the MBS dustup of 2003.
There has been massive selling of mortgages by an eclectic group of clients. In the early stages of this game servicers and originators led the charge. Today real portfolios joined in the selling to make for the ugly scenario we have today.
Swaps spreads are still being crushed. Two year spreads are 4 1/4 basis points wider at 43 3/4. Five year spreads are 4 1/2 basis points wider at 53 1/2. Ten year spreads are 11 1/2 basis points wider at 28 1/2. Thirty year spreads are 13 basis points wider at NEGATIVE 16 1/2.
Supperssing mortgage yields was an inefficient way to rescue housing (a lot of people refinanced who were not in financial duress), but part of the rationale was that lowering mortgage payments even for them gave them more discretionary income, hence more ability to consume, and hence was stimulative. Not that I though rescuing housing was a good idea. Housing got out of line with incomes and rentals, That means housing prices have to fall; the trick is to figure out how to restructure the debt, not how to reflate an asset bubble.
Curiously, the Fed has not announced formal inflation targets. Many Fedwatchers seem to assume the implicit target is something responsible, say 2-3%, but many other commentators have argued that the Fed needs to create much higher inflation to depreciate the value of all the debt weighing down on the economy. That implies at least a 6-7% level (but having lived through that sort of inflation, 7% or higher starts to wreak havoc with financial reporting, since the difference in the rate of inflation of various line items is not consistent and makes divining real performance a difficult. You effectively get a performance opacity discount added to the normal equity risk premium).
But would that really be productive? Not in a setting of overburdened consumes with no wage bargaining power. We’ve been on that theme, and Marshall Auerback concurs:
The more I think about it, the more it seems to me the mainstream academic economic emphasis on creating inflation to fight debt deflation is somewhat muddled. The point is to relieve the debt service burden. Ideally, you then want the following:
1. Lower nominal private interest rates that allow debt refinancing for those still solvent.
2. Higher nominal incomes for debtor households.
3. If insolvency is a large enough issue, either higher nominal asset prices to reduce bankruptcy, or a clear method of debt restructuring.
1 & 2 get you part way there anyway with lower discount rate, higher expected future cash flows.Not obvious to me how a 5-6% consumer price inflation would accomplish any of these three. How is gas at $4.00 a gallon, import prices up 10-5% y/y going to help indebted households? How are higher energy and metal and ag prices going to help businesses that use these as inputs make more profits, higher more people, and pay higher wages? Something seems really off in the mainstream prescription. I get that conceptually higher inflation erodes the real debt burden, but the “inflation” has to be of the sort that increases household money incomes. Labor surely does not have the bargaining power to forces wages up with prices in this environment. Real wages would be likely to erode. That cannot be good for debt service.
Back to the immediate question: what does this mean the Fed will do?
Despite the brave “helicopter Ben” talk, and the criticism Bernanke has made of Japan not pursuing quantitative easing aggressively enough (the Japanese beg to differ on this issue, they think not cleaning up the banks early on was their big problem). the Fed has gone to some length to claim that what it is doing is not QE but intervening to make credit more available in target markets. Indeed, its March announcement that it was going to buy up to $300 billion of Treasuries over six months, rather than a target, seemed even at the time a bit peculiar. That level wasn’t enough to make much of a dent in a mushrooming Treasury calendar, and announcing a fixed amount and a timetable actually tied its hands. The surprise announcement (it had been expected earlier, so investors had sort of given up and were caught off guard) worked for a while, but the content of the plan reduced the surprise element via its specificity (so investors take note: getting the transparency you want may not always be good for you).
Fedwatchers have said the Fed does not intend to change its posture at its June or July meeting. But the Fed’s pattern has been to be slow to act and then overreact. But would real QE work? My German client reminds me that the Fed has unlimited firepower and in the German hyperinflation, bunds were the last asset to break down. But here, if the Fed were to step up purchases systematically, it could very well wind up owning the market. How many investors would decide to sell into its bid? So QE would indeed create inflation, but might not control bond yields as much as the Fed hopes unless it is willing to buy whatever it takes to hold a given interest rate. The Fed does not appear willing to do that (or more accurately, to risk that it might balloon its balance sheet to a monstrous level to accomplish that, particularly now that the conventional wisdom is that the economy is getting better).
The irony is that this may wind up being a replay of 1936, when the economy started looking better and the government, worried about deficits, tried cutting spending and plunged the economy back into its morass. But with tax revenues and programs already passed, Team Obama couldn’t trim the fiscal sails even if it wanted to. The brave talk about reducing the deficit down the road does nothing for the Treasury supply hitting this year.
Now the Fed may get a mini-reprieve. If Thursday’s 7 year auction (a weird maturity), goes well, the market may stabilize and recover a tad. There are some other possible short term ways out, but they require cooperation.
The Japanese and Chinese do not want to see the dollar fall. Europe was not much in the way of a net importer even when the economy was more robust, and its outlook near term is worse than that of the US. If the dollar weakens, it means lower import demand at a minimum, and it could portend worse: a reversal of the seeming recovery (we never bought the “growth by 3Q story, but let’s stick with party line for now), which in combination with a weaker dollar could put trade back on the ropes, and a disorderly fall in the dollar could produce real upheaval. The Japanese yen is much higher than the authorities want it, and they have already threatened intervention. That talk drove it down to nearly 100 to the dollar, but it went back to the 94-96 range. They’d much rather have it at 105-110.
And both the Japanese and Chinese are likely to still be holding a lot of longer maturity Treasury debt (you can’t turn a supertanker quickly), so they are taking big time losses on any holdings. And even if they were to buy on the short end to keep their currencies down but the long end goes haywire and the US economy goes seriously in reverse, it’s a Pyrrhic victory. Yes, their currency will be favorably priced, but no one here will be buying much of their goodies.
Now they do not want to be big time, long-term buyers, but a surgical intervention to slap the market might not be a bad gamble, The notion would be to keep the Treasury market from getting too sloppy for at least a few months till the rest of the world economy was on a bit firmer footing.
And you’d want to do it in a noisy fashion. Politically, the Chinese could not announce a move like this, for it would be badly received at home, but the Japanese might publicly announce intervention to lower the yen and then let it be known in the markets that it would be buying longer dated dollar bonds. But the buyers would want everyone to know that they were a’coming into the market, presumably in size. That would change psychology for at least a while and would give the Fed some breathing room.
The Fed did call the Bank of Japan and asked it to buy Treasuries during the 1987 crash, and the BoJ dutifully put the word out to Japanese banks. But the Fed is very unlikely to prevail on China or Japan in less than an emergency, and I doubt they’d take this course of action on their own, as much as it might, when all the bennies are factored in, be a viable near-term strategy.
Note I am not saying this is a good choice, but a “less bad” choice, and that it is a strictly short-near term gambit to catch investors off guard and reboot the bond markets at a higher price.
The bigger problem is there is no obvious end game for the US-China co-dependence. For China to build a consumer economy is a ten to twenty year process. and a movement in that direction means higher wages, lowering their competitive advantage. But as Herbert Stein said, that which is unsustainable will not be sustained, and we may see his dictum proven out sooner than anyone would like.