Lordie, if this Reuters article is to be taken at face value, the Fed is even more detached from reality than I feared. The Fed does not understand why the Treasury bond market had a mini-panic last week. Is it that investors believe the “green shoots” story and are seeking riskier assets? Or is it that they are worried about burgeoning Treasury auctions and a possible fall in the dollar?
Note there is another theory, that it was Fannie and Freddie moves to manage their duration risk that caused the mess. However, it did appear that the selloff in the dollar and longer Treasuries was triggered by Standard & Poors’ announcement that it was putting the UK on negative watch, meaning it is at risk of losing its AAA rating.
While both factors, a shift to riskier assets and worries about a tsunami-like incoming tide of Treasuries, bizarrely, are in play, from what I can tell, the second, the fear of the growing Treasury calendar, is the big driver. Look, the Chinese have done everything but put up a billboard in Time Square to let the US know that it is not happy about US fiscal deficits (really, it ought to be, they need the economy to be something other than prostrate) and has moved aggressively to the short end of the yield curve.
So we have two possibilities. Either the Fed is as completely clueless as this story suggests it is, or it is coming to realize that it cannot, like the Wizard of Oz, manage all the variables it is trying to control and tune things as it would like. Doug Noland offers a similar line of thought (hat tip Andrew U):
The notion that there is a system price level easily manipulated by our monetary authorities to produce a desired response is an urban myth. During the 2000-2004 reflation, I would often note that “liquidity loves inflation.” The salient point was that the Fed could indeed create/inflate system liquidity. It was, however, quite another story when it came to directing stimulus to a particular liquidity-challenged sector. Almost inherently it would flow instead to where liquidity – and resulting inflationary biases – were already prevalent.
The Fed’s reaction strikes me, behaviorally, as a re-run of 2007. The Fed saw the credit contraction as only the subprime mess, therefore something familiar, sat on its hands, then overreacted. As things appear to be working out not to its liking, it its reflex again is to hold pat. I’d expect the Fed to overreact as before if it comes to believe it has a real problem on its hands.
The fact set this time of course is wildly different. The Fed is trying to achieve aims that are not internally consistent, namely, prop up asset prices by directing credit to preferred sectors, and create positive inflation expectations.
Keeping yields (or more accurately spreads, the Fed claims it is only trying to control spreads) while also trying to raise inflation expectations, albeit modestly, is a conflict. Higher inflation expectations mean higher yields, particularly on long dated assets like mortgages. And enough observers think privately that the Fed secretly wants to create much more significant inflation, say 5-6%, to alleviate the real debt burden on households. Those sorts of worries among bond investors are cause enough for some to abandon the long end of the curve.
And the “will the Fed amp up its quantitative easing” is yet another concern. Even though the Fed could in theory control rates at the long end of the curve via its unlimited firepower, Mr. Market could well play a game of chicken. If the Fed decided to hold a particular long rate, it could well wind up owning that market. The Fed is no doubt well aware of this risk, which may be the big reason it is holding off, and hoping this problem somehow resolves itself.
The Federal Reserve is studying significant moves in the U.S. government bond market last week that could have big implications for the central bank’s strategy to combat the country’s recession.
But the Fed is not really sure what is driving the sharp rise in long-dated bond yields, and especially a widening gap between short and long term yields.
Do rising U.S. Treasury yields and a steepening yield curve suggest an economic recovery is more certain…..
Or does the steepening yield curve mean investors are worried about the deterioration in the U.S. fiscal outlook, or the potential for a collapse in the U.S. dollar….
Another possibility is that China, the largest foreign holder of U.S. Treasury debt, has decided to refocus its portfolio by leaning more heavily on shorter-term maturities.
With officials still grappling to divine the factors steepening the yield curve, a speedy decision on whether to ramp up the Treasury debt purchase program or the related plan to snap up mortgage-related debt seems unlikely.
“I’m in wait-and-see mode,” said one Fed official …”We laid out the asset purchase plan and we’re following it. That is going to have some affect on various interest rates, but together with a hundred other things. So I don’t think we should be chasing a long-term interest rate,”…
Economists at Barclays Capital in New York have argued that the Fed should announce plans to increase its planned purchases of longer-dated Treasuries to $1 trillion from $300 billion to drive yields back down….
But the Fed is not so sure, and officials note that corporate bond spreads have narrowed over U.S. Treasuries, and that although mortgage rates have risen, they are still low..
Yves here. The funniest bit of the piece is a part I omitted, where the Fed types figured that the jump in yields couldn’t be due to the big supply, after all, that had been known for some time. Gods, they actually believe that rational expectations stuff. People are inertial, and Bill Gross and his buddies have believed that the Fed would protect him, since it has done such a good job until now.