Talking Numbers

Does the Fed have a handle on interest rates?

Does the Fed have a handle on interest rates?

As anyone following the markets knows by now, the Federal Reserve Bank is going to begin tapering its bond-buying stimulus by $10 billion to $75 billion per month.

Fed Chairman Ben Bernanke made it clear, though, that the Fed will continue buying bonds as part of its "quantitative easing" ("QE") policy. In his remarks to the media on Wednesday, Bernanke said:

"Starting in January we will be purchasing $75 billion of securities a month, reducing purchases of Treasuries and mortgage-backed securities by $5 billion each. It's important to note, though, that even after this reduction we will be still expanding our holdings of longer term securities at a rapid pace."

In other words, the Fed will keep buying bonds – and lots of them – with long-term average maturities, albeit at a decreasing rate. Increasing the duration of their total bond portfolio is pretty much in line with what they did in "Operation Twist" a couple of years ago. Then, the Fed got out of a total of $687 billion in bonds with less than six year to maturity and got into bonds with maturities of six years or more.

(Watch: Fed policy has been destroying markets: Pro)

When bond prices go down, their yields go up. Likewise, when bond prices rise, their yields go down. So, by buying more long-term bonds relative to short-term bonds, the Fed is essentially trying to flatten the yield curve compared to what it would otherwise be.

So, why would the Fed want to keep long-term rates low? Bernanke explained it this way:

"Our sizable and still-increasing holdings will continue to put downward pressure on longer-term interest rates, support mortgage markets, and make financial conditions more accommodative, which in turn should promote further progress in the labor market and help move inflation back toward the committee's objective of 2%."

When 2008 began, the yield on a 1-month Treasury note was 3.09%. By December 19, 2008, they were at 0.0%. No, that's not a typo. That really was the yield of a 1-month bond half a decade ago. In the five years since, the highest it traded was around 0.17% (again, that's not a typo) back in 2010.

(Read: How the Fed's pullback of stimulus could affect you)

The same couldn't be said for the market benchmark, the 10-year US Treasury bond, the rate to which a lot of lending is tied in the marketplace.

At the start 2008, the 10-year was trading with a yield of 3.91%. As the financial crisis hit later in the summer of that year, it closed as high as 4.76%. The Fed began its several series of bond-buying programs (known as "quantitative easing" or "QE") and the 10-year yield began falling. By July of last year, it was trading as low as 1.43%.

It more or less stayed below 2% until May 2013. That was when Bernanke hinted that a taper in QE, which by then had reached $85 billion month in not only US Treasury bonds but also mortgage-backed securities. As of Thursday's close, the 10-year was trading at 2.94%.

So, even though shorter-term rates remain low, longer-term rates have been moving up because of the massive bond selloff that began in May as investors feared they'd lose the Fed as the biggest bond buyer of all time.

As Bernanke pointed out, lower longer-term rates stimulate growth by making borrowing costs cheaper for, say, businesses. In an improving economy, the yield curve starts to steepen but, in the Fed's eyes, the economy doesn't have the capability yet to let them get too high.

(Read: US growth hits fastest stride in nearly 2 years in Q3)

While they keep shorter-term rates about as low as they could go and as they try to ease out of quantitative easing, the Fed can still try to get a handle on long-term rates by buying longer-termed bonds relative to shorter-termed ones (again, at a lower rate). That is, they're still trying their best to keep the yield curve under relative control as they slowly withdraw from QE.

What's next for the yield curve? In the video above, Andrew Busch, editor and publisher of The Busch Update, looks at the fundamentals of the taper. Looking at the technicals for yields is Jeff Tomasulo, Managing Partner at Belpointe Alternative Investments.

Watch the video above to see Busch and Tomasulo discuss the future of interest rates.

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