Yves here. As Wolf describes, in our brave new work of super-low interest rates, the 10 year Treasury breaching 3% was regarded with fear and loathing by the officialdom. Now with the Fed’s reassurances that the Fed funds rate will remain at just about zero for the foreseeable future, the stock market has popped the Champagne. But will the impact of the withdrawal of support for bond prices impact stocks sooner than the current rally would have you believe?
By Wolf Richter, a San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Originally published at Testosterone Pit.
Treasuries have been skidding, and yields have been on a tear. Today the 10-year yield hit the psycho-sound barrier of 3%. What happened last time this phenomenon occurred? Well, yields bounced off and fell – because the mayhem they’d triggered around the world gave the Fed conniptions and caused it to back off.
The last time the 10-year yield hit 3% was in early September, for the briefest moment. But the last time it traded above 3% for any period of time was in 2011. In February that year, it spiked to nearly 4% as QE was petering out. That gave the Fed cold feet, and it unleashed another wave of QE which drove yields down to 2% by the end of 2011, and to a ludicrous 1.38% in July 2012.
Ludicrous because it just about guaranteed hapless investors a loss. If they sell it as yields are rising and values are tumbling, there would be a loss of capital. If they hold this paper to maturity, inflation would eat up its value and coupon payments would not be enough to compensate for it. Take your pick!
The Fed is trying to stir up 2% inflation, as measured by the core PCE index, which is even more unrealistic for households than the regular CPI. In this scenario, inflation as measured by the CPI might be 2.5% or more, sending the Fed to nirvana, and holders of these notes to bondholder purgatory. They’d lend money to the government for ten years at a loss. Conversely, with the government (and many corporations) borrowing at a profit, it would be smart to go on a borrowing binge, no matter what. That you can’t manipulate a wheezing economy back to health over the long term based on this lofty principle is obvious to all but perhaps the primary beneficiaries, our over-indebted corporate America, the Fed, and the government.
But it did lead to equally ludicrously low mortgage rates and to a historic junk-bond bubble with yields of these risky things dropping below the interest that 5-year FDIC-insured CDs used to pay before the Fed purposefully mucked up the lives of savers. In broader terms, it lead to the most gigantic credit bubble mankind has ever seen. Risks no longer mattered, and pricing of risk was removed from investment equations. What it did not lead to was vibrant economic growth.
But in May, taper talk started bubbling up and turned into the taper tantrum over the summer. Bonds fell hard, and 10-year treasury yields soared from 1.61% in early May to 3.01% in early September – nearly doubling in four months. Municipal bonds got clobbered. Mortgage rates soared, rendering homes, whose prices had been shooting up for a couple of years, much more expensive to buy. Emerging markets got the jitters. Their currencies fell off a cliff, and their inflation rates roared ahead. This 3%-land suddenly looked scary.
The Fed got cold feet once again and backed off its taper threat, and yields plunged again. Well, a little. They bottomed out in October, with the 10-year yield approaching 2.5%. Then yields turned around, and now, with taper talk back on track, and the first $10-billion slice scheduled to take effect in January, the 10-year yield pierced the psycho-sound barrier of 3% for the second time this year.
Yet the Fed hasn’t actually done anything. It’s still just talking. And it’s still printing $85 billion a month to buy Treasuries and Mortgage Backed Securities. These moves in the bond market are simply in anticipation of what might happen when or if the Fed actually tapers.
Those hapless souls who bought treasuries with longer maturities in the summer of 2012 are contemplating massive losses. They were tricked and fooled and hoodwinked by the Fed. So be it. But Treasury yields impact the real economy too, where people are struggling to get by and where homebuyers have to re-figure out how much of a house they can afford, given skyrocketing home prices and soaring mortgage rates.
Rates for 30-year fixed-rate mortgages with conforming loan balances ($417,000 or less) hit 4.64% just in time for Christmas, up from 3.59% in early May, and retail homebuyers – not private equity funds and sundry investors – have pulled back. The Mortgage Bankers Association’s Purchase Index dropped 11% below the same week last year – as interest costs paid by homeowners on these mortgages have jumped by nearly 30% in seven months [read…. The Multi-Pronged Mortgage Debacle Next Year (So Long, “Housing Recovery”).
It remains to be seen if the 3% yield on the 10-year Treasury was just a brief foray into utterly forbidden territory during thin holiday-season trading, a forgettable event with little impact and no long-term consequences, or if it was a sign of things to come when the Fed actually starts tapering its bond purchases, and when the cost of borrowing money for the longer term might be allowed to meander back up to where it would normally be in a less manipulated but saner economy.
All the Fed has to do is announce an unlimited bid for bonds at a lower rate/higher price, and long term rates will fall to that level even with no QE. However the geniuses at the Fed don’t seem to be aware of this.
Yes….but isn’t that just another form of QE when the Fed buys U.S. Treasury Bonds? Remember…. they are trying to stop buying things. When they buy stuff it is with money they just created from nothing which increases the money supply. They want to prove that they have created enough money for the economy to power itself without the Fed being the “Purchaser of Last Resort”.
Until that money reach the pockets and accounts of the working people walking the streets, not going to happen. Right now it is only doing the rounds in bank and finance corporation accounts. And those have little needs for consumables outside of whatever oversized tastes their employees have developed.
Futures markets in hookers, cocaine and support yachts are through the roof…
QE itself is really nothing special; it’s just regular open market operations on a bigger scale. The Fed buys and sells bonds on a daily basis to manage the short-term rate and has done so for a very long time.
Now think about your accounts at your bank. Like most people you likely have a checking account and a savings account. One day your bank contacts you to say they would like you to spend more, and to facilitate this they’ve moved some of your dollars from your savings account to your checking. Obviously this has done absolutely nothing to increase your spending power; it has simply moved your dollars around, which is exactly what QE 1 and 2 did. Perhaps you didn’t spend more as the bank had hoped, so your bank calls to let you know they will be transferring $85 per month from your savings to your checking until you do so, and now you have QE3.
For banks the Fed takes dollar balances from their securities accounts (like a savings account) and moves them to the banks’ reserve (checking) accounts. The quantity of dollars the bank has is unchanged, no more and no less. The only real change is that, as with your checking account, the reserve account earns less interest than the savings/securities account.
The Fed is offering to purchase treasuries, not confiscating anyone’s treasury holdings and replacing them with reserves. Anyone who agrees to sell the treasuries to the Fed must believe the sale is to their advantage howsoever they may calculate that advantage to be. Since reserves are needed to buy treasuries, current holders of treasuries may be selling them to the Fed if the Fed is buying them at a value well over what the seller expects to buy them at the next treasury auction.
It isn’t enough to just announce they would buy at a level- they actually have to follow through.
They wouldn’t have to buy much. Because sellers can always go to the Fed for a given price, buyers would be forced to beat it just to stay in the game.
No, they can’t just announce a price above the market they will buy and buy a small or no amount and hope to maintain that price. If they set the market’s highest price, then all willing sellers will sell to the Fed. The now higher ask will reduce the numbers of actual potential buyers outside the Fed. The Fed would have to buy all the offered supply until the numbers of willing sellers and willing buyers (those not the Fed) rebalanced at the higher ask. The Fed did QE the way it did because the supply of the bonds was increasing faster than they could buy them (the US government was running trillion dollar deficits for 4 years.
I think it’s important to realize that we don’t borrow money that we create. Instead we decide how much interest we will pay to people who want to hold Treasuries. And not many Treasuries are held by the bottom 50%.
‘It remains to be seen if the 3% yield on the 10-year Treasury was just … a forgettable event with little impact … or a sign of things to come.’
It’s a hard act to follow such a bold assertion, but let’s try. Over the past 60 years, the yield premium of the 10-year T-note over the 3-month T-bill has averaged 1.57 percentage points, with a standard deviation of 1.22.
Currently, the 10-year T-note yields 3.00% and the T-bill 0.06%, resulting in a premium of 2.94%. This premium is more than one standard deviation on the high side of the average, meaning that premiums above today’s 2.94% occur only about 15% of the time.
As recently as Oct. 2008, the premium was 4.13%. So even steeper yield curves are (at least briefly) possible. However, if the Fed indeed holds short interest rates at zero until 2015, today’s yield curve is steep enough already that more steepness (achieved by the 10-year T-note yield heading higher into the threes) is a low probability bet.
Well, there is also the possibility that despite what the Fed says, the short term rates will rise much sooner than expected. However, I agree with your analysis.
The only way the Fed could lose control of the short term rate would be a complete breakdown of the political system whereby the populace literally rejects the dollar, or a legitimacy crisis. So long as the central bank commits to a target rate no one else has the juice to push back.
Good God, you are dense. I didn’t write the Fed would lose control of the short rates. I only wrote that the short term rates could rise much sooner than the Fed is telling us as of today.
” That gave the Fed cold feet, and it unleashed another wave of QE which drove yields down to 2% by the end of 2011, and to a ludicrous 1.38% in July 2012.
“Ludicrous because it just about guaranteed hapless investors a loss. If they sell it as yields are rising and values are tumbling, there would be a loss of capital. If they hold this paper to maturity, inflation would eat up its value and coupon payments would not be enough to compensate for it. Take your pick!”
Well, to quote somebody: They ain’t no free lunch!
The gov’t has been offering a free lunch in the form of almost risk free bonds for a long time. So long that people think that they are entitled to it. Well, these days entitlements, like the Old Gray Mare, ain’t what they used to be.
There ain’t no free lunch?
I suppose, unless you are a too big to fail bank or automaker!
The only thing that really matters is the interest the Fed is paying on bank reserve accounts. Contrary to conventional belief, savers are interest rate takers; their only alternative to accepting these pitiful low short rates is gambling either in the bond or stock market. What sensible person would increase bond or equity positions at current prices? Only those running other people’s money and earning rake-offs win or lose. The market hijinks will continue until they end, but guys who try to use logic to determine market tops (and bottoms) end up driving cabs.
QE should be very aggressively reduced, and I hope incoming FED chair Yellen has the panache to do it. Total balance in the FED’s reverse repo accounts are roughly $95 billion after last week’s $23 billion QE dish into SOMA (think about the acronym for this account title at the FED in the context the same term was used by George Orwell in his book “1984”).
This development suggests the recipients don’t need the money and are merely awaiting a more promising speculative play in terms of financial asset prices, and/or are building cash equivalents for year-end window dressing. Neither of these objectives are an overriding public interest. The Bloomberg financial conditions index is currently roughly two standard deviations above the average of the January 1994-June 2008 period. (See: http://www.bloomberg.com/quote/bfcius:ind)
The Velocity (turnover) of money in the economy is also currently at all-time historical lows, further evidence that it’s not the amount of money in the system that is the issue, but it’s distribution: http://research.stlouisfed.org/fred2/graph/?chart_type=line&s%5B1%5D%5Bid%5D=M2V&s%5B1%5D%5Brange%5D=5yrs
Just wondering why an article in favor of high interest rates would be published on this site. Why exactly are low interest rates “ludicrous”? Is not anything over zero ludicrous for a fiat currency? Very disappointed that this trash would see the light of day here. It’s capitalism that is ludicrous, not low interest rates!
The state we are in now is “financial repression,” where central banks intervene to push interest rates below inflation. That is not capitalism, that is a government-engineered subsidy to the banks that is estimated to be worth about $350 billion a year in the US alone.
The result is that savers and pension funds lose. Old people die faster since they can’t earn any income on their meager savings.
Interest rates should allow savers to earn at least a modest REAL return (as in exceed expected inflation rates) with higher premiums reflecting the credit risk.
That has nothing to do with fiat currency either, BTW. Any two parties can create credit.