Interest Rates Rising Again Despite the Fed's Actions

The Fed's bid to lower long-term interest rates on home mortgages and corporate debt is already running into trouble.

In the aftermath of last Wednesday's announcement that it would buy back $300 billion of 2-10 year Treasury securities, yields on benchmark 10-year notes were cut 51 basis points, from 3.02 percent to 2.51 percent in a matter of minutes.

But rates have since crawled up on Thursday and Friday, and show no sign of falling today, leaving the market just 36 basis points lower than before.

CNBC.com

The improvement in corporate and mortgage rates has been even smaller, as credit spreads have widened to offset some of the drop in benchmark rates.

The decline in borrowing costs is too small to have a significant effect

Most investors have concluded the Fed's quantitative easing program is an empty gesture. Buying back $300 billion of government debt is not enough to make a sustainable difference at a time when the government will be issuing far more than this to fund the cost of bank rescues and a budget deficit equivalent to more than $3 trillion over the next two years.

In terms of bond pricing, net issuance in the 2-10 year maturity spectrum will affect interest costs on Treasury debt, and net issuance will be increasingly sharply, even after the Fed's buy back program is implemented.

The only way to have a sustainable impact would be to buy much more debt and absorb all or a significant proportion of the net new issues. But that would involve "monetizing" a substantial part of the federal government's borrowing needs this year and next, and lay the Fed open to accusations that it is engaged in inflationary financing.

The Fed is trapped. The current buy back program is too small to have more than a symbolic effect. Expanding it, though, would trigger fears about inflationary financing and risks bringing on the rise in bond yields and collapse in confidence and the currency the Fed is desperate to avoid.

Prices and Quantities

The type of quantitative easing announced by the Fed last week affects both the quantity of credit (money supply) and its price (yields and interest rates). But the $300 billion buy back program seems to be focused on altering prices rather than volumes.

The amount is too small to have more than a negligible impact on the overall money supply (it amounts to just 4 percent of M2). It is larger in relation to bank reserves (about 40 percent). But the boost to reserves from buying back federal debt is dwarfed by the boost from buying back much larger quantities of mortgage-backed bonds and other private sector assets.

In any event, the problem is not the quantity of reserves in the system but inability to turn it into loans, and the higher cost and tougher terms on new credit. Simply increasing the monetary base will not solve that problem.

In theory, the Fed could flood banks, households and corporations with so many excess reserves it saturates even the new, higher demand for cash, and forces them to lend the money on or invest in higher-risk assets out of sheer desperation.

But experience during both the Depression and Japan's lost decade strongly suggests that demand for liquid cash instruments is almost infinite during a crisis. To saturate that demand, the Fed would need to create huge amounts of liquidity that would then prove very difficult to withdraw in a timely manner once recovery got underway and pose an immense danger of future inflation and devaluation.

Buying $300 billion of Treasurys will not create anything like that amount of new money (though some of the Fed's other programs might).

So the real aim is not quantitative easing but pushing benchmark yields down by buying a large amount of the credit outstanding in a relatively thin part of the yield curve (the buy back is equivalent to about 16 percent of all government debt maturing between 2011 and 2017)

Limits of Fed Power

Like King Canute's disbelieving courtiers, Fed officials are about to learn a hard lesson in the limits of their power.

Central banks are accustomed to manipulating the short-end of the yield curve through open market operations in Treasury bills. But their power stems from the minimum reserve requirements commercial banks are required to hold by law (in other words the Fed has a monopoly on creating something the banks are required to own by law).

Fed officials may be over-estimating their ability to influence the wider bond market. No one has to hold U.S. Treasury debt (though the Fed and the Treasury may be able to exploit the newfound public enthusiasm for ultra-safe instruments to some extent). Instead, if the Fed pushes yields down to artificially low levels, the Treasury will struggle to attract sufficient funds to finance its borrowing needs.

Prices and yields observed in the bond market prior to the Fed's announcement suggest investors need a return of at least 3.00 percent per year to lend to the government for a decade.

The Fed's buying program is aimed at suppressing borrowing costs by providing a new source of demand for medium-term benchmark paper. But that has driven yields below the market's true equilibrium level.

There is no reason to believe investors have changed their views. If they wanted 3 percent or more before the Fed's announcement, they almost certainly still want it now.

Nor is there any indication the government can issue new debt at much below this level. Investor appetite for long-term government paper remains limited.

AP

Most of the government debt issued since the start of the year has been very short term, maturing before the end of 2012 ($148 billion, net), with only a small proportion maturing at 2018 or later ($65 billion). At the last two auctions, the government was forced to pay 2.71-2.81 percent (February) and 2.98-3.04 percent (March) for 10-year paper.

By trying to push interest rates down below this level, the Fed is simply creating a false market.

Investors will happily buy new federal debt at 2.50-3.00 percent so long as they remain confident they can sell it back to the Fed (i.e. the government itself) at 2.50 percent. In effect, arbitraging the Fed against the Treasury. But that will limit new issues at these intermediate maturities to $50 billion a month for the next six months.

If the government tries to issue more than this, or wants to continue beyond the six-month limit, rates will move back up, unless the Fed increases the size of the program further. To sustain yields below the market-clearing program, the Fed program will need to increase indefinitely and the Fed will end up absorbing a large share of the new debt.

Notional Rates, Real Rates

The Fed's attempt to manipulate the yield curve risks driving a wedge between the "notional" cost of credit and the "real" one.

This has already happened at the short end of the curve - where the Fed and other central banks have driven down official short term rates but rates available to borrowers have remained stubbornly high, and banks have also imposed a range of tougher conditions, raising the effective cost of loans still further.

In theory, credit should now be plentiful and cheap, following the Fed's actions. In practice, it is scarce and expensive.

• Slideshow: Where The $200k+ Crowd Lives

The same problem will now be replicated at the middle and back end of the curve. Low benchmark rates will be accompanied by higher credit spreads, tighter covenants and insistence on lower gearing ratios and higher equity.

Former Fed Chairman Alan Greenspan wondered why the back end of the curve proved so stubborn when he tried to raise rates in 2004-2005. His successor may end up wondering why the back end is so invariant when he is trying to lower them.

Copyright 2009 Reuters. Click for restrictions.