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Now Start Watching Interest Rates, Part 3

by John Rubino on November 12, 2010 · 18 comments

In the US, perception management is now the key to public policy. Which means the latest round of money creation and bond buying will only “work” if consumers and investors fall for what is essentially a con — the idea that fiat currency is the same thing as wealth.

If they instead figure out that their savings are being destroyed while their government’s indebtedness explodes, they won’t invest in stocks and bonds or buy new houses and cars.

So everything depends on the marks not catching on, and all eyes are on stock prices, the dollar exchange rate, and long-term interest rates. Any of these, by gapping in the wrong direction, can cancel out the psychological impact of the Fed easing. And then everything falls apart.

How’s the con going? Not so well. The dollar’s holding up. Stocks are choppy but remain above their pre-QE2 levels. But interest rates are departing from the script. It seems that even with all the prospective bond buying, not everyone is convinced that lending money to the world’s most indebted government for 30 years is a “risk free” strategy. Long rates are starting to move up, enough to warrant two Wall Street Journal articles in one day, excerpted here:

‘QE2’ in the Dock: Some Yields Are Going Up
By Mark Gongloff

The Fed’s latest “quantitative easing” program is designed to bring down interest rates, but some are moving up instead.

Rates, which rise as the price falls, have risen lately as investors avoid U.S. government debt—including a new 30-year bond auctioned on Wednesday. That has generated market anxiety that the Federal Reserve has lost control of rates and inflation expectations.

But many observers are waiting for the Fed to at least start the program before making any judgments about it. The rise in yields on 30-year bonds hasn’t been duplicated among shorter-duration bonds, which the Fed says it will focus on buying, and has been less pronounced for the more-important 10-year Treasury note, which is the benchmark for mortgages and corporate debt.

“It is premature to say that the Fed has failed or that this has backfired,” said David Ader, chief government bond strategist at CRT Capital. “Logic tells me that, once the program gets under way and people are selling to the Fed, that rates will go lower, significantly so.”

That is the Fed’s plan. The Fed last week committed to spending a total of $600 billion in freshly printed money on Treasurys before next June, effectively soaking up all of the new debt issued by the government.

The program of buying Treasurys is designed to keep Treasury yields low, thereby stimulating the economy and pushing investors into riskier assets such as stocks and corporate bonds. That’s part of the Fed’s state goal of fighting deflation.

The New York Fed will begin buying on Friday with purchases of $6 billion to $8 billion, according to a schedule released by the central bank on Wednesday. By Dec. 9 it plans to have bought about $105 billion in Treasurys, including a handful of Treasury Inflation-Protected Securities, or TIPS.

Having such a big, unflinching buyer in the market should keep prices high and yields low.

But the opposite has been happening lately. A Treasury auction of $16 billion in new 30-year bonds on Wednesday was poorly received, with the government having to pay a slightly higher yield than expected to attract buyers.

The 30-year Treasury bond’s price has fallen nearly 12% since Aug. 26, just before Fed Chairman Ben Bernanke hinted at QE2 in a speech at Jackson Hole, Wyo. The yield has jumped to 4.239% from 3.53% in that time, and at one point on Wednesday surged to the highest since May.

And Treasurys have weakened despite fresh fears about European sovereign debt, which in the past has been a boon to safe-haven U.S. government debt.

Markets Fight the 30-Year War
By David Reilly

It’s too early to say what the quick rise in Treasury yields says about the Federal Reserve’s latest policy moves. But they are a reminder, particularly for banks, that any eventual market turn could be fast, furious and painful.

The yield on the 30-year Treasury bond has jumped more than 0.7 percentage point since the Fed hinted at more bond buying in late August, of which almost 0.2 percentage point has come since last week’s announcement the program would total $600 billion.

The 30-year bond is a canary in the coal mine when it comes to inflation fears. Because of their long duration, such bonds are most sensitive to changes in inflation expectations. They also are receiving little support from the Fed’s buying program.

Wednesday’s weak auction for $16 billion of 30-year bonds showed how nervous investors have become in this regard. If inflation eventually does materialize, yields could move in an even more significant fashion, leaving many investors in the lurch. Over the past year, buyers of Treasury and mortgage debt have held their nose while purchasing ever-lower-yielding paper. Banks in particular have bulked up holdings of government and mortgage-backed debt due to tepid loan growth.

Many investors hope, should the rate environment change, they will beat others to the exit. That’s a risky strategy. Shorter-dated bonds also hold risks, albeit to a lesser degree.

No wonder Federal Deposit Insurance Corp. Chairman Sheila Bair warned in a speech last month that banks should be able to withstand rate rises of as much as five percentage points over a two-to-three-year period. That is extreme. But investors also should be asking themselves if they are prepared for rapid shifts.

  • Bruce C.

    Public policy, and especially Fed/monetary policy, is so convoluted and screwed up that one is forced to choose between one subset of goals and initiatives and another because many of them are mutually exclusive or contradictory.

    For example, one stated goal of Bernanke is to create inflation between 1.7 and 2.0%. Now, if you believe the Fed will achieve this then you should expect bonds rates to increase proportionally, so it makes sense to sell them now so as not to lose principle. If enough people do this then it becomes self-fulfilling: bond rates increase. This is being done ahead of the Fed’s QE II purchases, so it will be interesting to see if the Fed can bring those rates back down. I suspect that the fear of the Fed’s desire for inflation will fuel more selling than the Fed will buy so the interest rate trend should remain permanently elevated or even continue to rise. Equities would fall.

    Now consider the stated corollary to the inflation goal: to lower long-term interest rates. If you choose to focus on that agenda and believe the Fed will succeed on that front, then it would make sense to hold any bonds one has to enjoy the “guaranteed” rise in principle, and perhaps even to buy more. Such actions would reinforce the downward pressure on rates that the Fed desires, and be self-fulfilling as well. Equities would rise.

    And what about one of the Fed’s IMPLIED goals: to lower the dollar index. If you like that idea and are willing to bet on the Fed’s success then may I suggest going long on every other currency but the Yen and Yuan, or shorting the dollar, or both. Then one could arbitrage lower US bond yields and higher foreign bond yields. Equities would then rise because corporate profits would accelerate due to risk-free global investments using all that cash they have PLUS the extra boost created when those foreign currency gains are converted to dollars.

    But wait. Another IMPLIED Fed goal is to increase US exports. If the Fed succeeds in that – and who’s dumb enough to doubt the Fed, right? – then emerging and developing market equities will fall and international US-based equities will rise. And US bond rates will fall because of all those extra dollars coming back from the international importers have to go somewhere (i.e., US Treasuries).

    Did I mention that the Fed also wants to increase employment? I think Ben means US employment but he’s never been explicit about that. Anyway, if the Fed succeeds in that then that would mean QE would have to stop to put an end to national debt monetization and the easy money global charade, and leave businesses no other choice than to make money the old fashioned way. Interest rates up, equities up, the dollar up, and the government down.

    • T. Logan

      Bruce’s article nicely follows the implications of various FED moves. Thanks. One suggestion: “Principle” is not the same as “Principal”. You meant the latter, but spelled it as the former. For spelling-compulsives like me, the misspelling distracts…

  • Chris

    We are not sure how transparent Fed is. How much money had been spent and how are they spent, nobody knows. Are there anyone looking over the shoulders so that Fed is not meddling with the free market. Remember that if manipulating markets works, then the communist would have prospered. The whole world depends on the good functioning of the US economy. It cannot fail or the world goes down with it. A secret audit would be good. There is no point wondering this and wondering that.

    • tim

      “Is there anyone looking over their shoulders so that Fed is not meddling with the free market.”
      Chris, the Fed IS is a non-government body owned and operated by and for the benefit of the free market banks(ters).
      “Remember that if manipulating markets works, then the communist would have prospered.”
      Communist China is doing extremely well, and I would say that they are definitely manipulating their currency (it is pegged to the dollar). Manipulation of currency can pay off handsomely.

      Chris, why have a secret audit of the Fed? How would it being secret help anyone except for government and corporate insiders who would get to see it when you and I would not?

      • Chris

        Tim, looks like we will all end up in a very sorry state like the communist before they join us in the free market world. The whole world depends on a strong America. Cheating will only result in short term gain. But if everyone cheats, you will want to cheat too or you will become the biggest loser. America became the most powerful nation in the world because there is honesty and trust in the system. This is a long term thing.

      • edward

        China is no longer communist. The state does not own the means of production. Yes their political elites call themselves communist, but communism is defined as state ownership of the means of production. I would bet that Tim was referring to China years ago, i.e. The Great Leap Forward / Mao years. Not the current China that has freer markets than the US. Regardless, I disagree with Tim that there is no point wondering this or that. The fact is that there will be NO audit of the Fed anytime soon. Thus, we have to make educated guesses with the info that we have.

  • PeteCA

    John – when long-term interest rates really DO turn around, it will signal the “beginning of the end” for the vast Ponzi scheme that has been run by the US Gov’t (on its own debt). Once the price of that debt (specifically the interest rate paid on that debt) starts to spiral upwards … it is game over. The US budget will not withstand the dramatic increase in interest rate payments, and there is no way that future tax incomes can keep up with the required extra payments.

    For now, expect a Herculean struggle as the Fed spends more and more $ to confine these interest rates in a trading channel, while China (and possibly Japan & other investors) look to unload more of their holdings of UST’s onto the Fed.

    But it’s absolutely true that as commodity prices start to soar – and that’s already happening – that bond prices are trading far from their reasonable expectations. All of which implies … that when this Ponzi scheme does unravel, the jump in interest rates could be quite nasty.


  • Brad Thrasher

    “In the US, perception management is now the key to public policy,” John Rubino.

    Bingo! Spot on! Fiat currency is a virtual expression of value. Fiat currency should not be confused with anything that is real. Especially money. Now that the market is the sole determinant of value, perception is all that matters.

    Perception management of a virtual asset is what the paper money boys do.

    Does anybody know what comes after trillion?

    • MM

      According to George Bush a brazillian comes after a trillion.

    • Danny

      Quad –

      Most are confused about gold and money. I agree that gold has had it’s history as a solid currency. But a gold currency will make it easier for banks to keep stealing anyway. As a matter of fact, I would not be surprised if when all is set and done, the banks are the ones pushing for the gold standard. They will use it against us anyway.

      A paper currency can work as long as our government is kept in check. This will end when the people demand a stop to the looting. Enough is enough. Gold or no gold, stop the damn looting.

      • Brad Thrasher

        lol@MM and props for being first at recognizing a rhetorical question when you see one.

        Not sure I buy your premise Danny. (1) The only reason I’m not a thief is that I determined if it ain’t ten million it ain’t worth stealin’. My number used to be a million but inflation caused me re-evaluate. (2) I would suggest and defend if necessary that gold is check on currency manipulation. We went off the gold standard because they couldn’t steal enough. No system is perfect. We’ll never eliminate the looting, human beings are just to ingenious.

        If there’s a better idea I’m all eyes and ears.

  • PeteCA

    If banking problems persist in the USA – and there are rumors that Foreclosuregate could still precipitate a new round of bailouts – then “nationalization” appears to be an option that people are considering.

    Really … nationalization of the Wall St. banks?

    Let’s stop for a moment – and consider what that really means. Because our largely clueless politcians seem to be constantly transferring more and more losses of private institutions directly onto the public. I personally don’t mind if insolvent banks are put into receivership, and bond holders are forced to take the losses. This should have been done a long time ago.

    But has anyone stopped to realize that “nationalization” also transfers the entire risk of the global derivatives market directly onto the heads of the US taxpayers? Are we to believe that these bankers are going to go on playing outrageous games of chance, with high leverage and poor judgment, and that all the risks will now fall onto the US taxpayer??? You’ve got to be joking. We are really going to see a collapse of the global financial system, if someone doesn’t start introducing real risk management back into the financial system in short order.


  • http://chaosandconspiracy.wordpress.com CompassionateFascist

    @ Thrasher: Quadrillion, aka one “Rothschild”.
    @ PeteCA: The TBTF banks….nationalized the gov’t. Long ago.

  • http://www.pmbg.net Broker/Trader Kristopher

    The Federal Reserve has announced the next round of QE, which will start with pumping an additional $600 billion into our economy through the purchase of long term treasuries. This action is intended to stimulate economic activity by adding liquidity to domestic capital markets, which in turn should increase bank lending. The effects of QE2 (Quantitative Easing Part 2) will be unclear for quite some time, however US Dollar weakness is likely to persist considering the printing of currency is a side effect of such action.

    As economic uncertainty persists and fiat currencies continue to lose value, it would be prudent to diversify your portfolio into physical Precious Metals. These assets historically rise when currencies fall and serve as a safe haven during times of economic uncertainty.

  • Don Levit

    Perception is definitely the key.
    It seems that many people perceive we had 3 surplus years during the Clointon presidency.
    That is not true. We did have a surplus in debt held by the public, but intragovernmental holdings rose by more (borrowing from Social Security and other trust funds by the Treasury).
    So, even though we supposedly had a surplus, total debt rose.
    Don Levit

  • elwind45

    The free market selling to the Fed is natural. Since the program was announced many days before the action. The market had plenty of time to buy on rumour and sell on news. The rout in the thirty year is also natural because of the inflation implication of investing for such a long period. Our officials entered into a pack with the devil, when they shipped our industrial base to the far east. Now that the fall-out has began, nobody should be surprised.

  • Viji Varghese

    Lets face the facts here. This government’s debt is 100% of GDP and the bloodletting has no end in sight. With a yearly fiscal budget shortfall of about 10% the Fed is purchasing TREASURIES in order to cover the shortfall on the government balance sheet. Thus they are fulfilling two objectives; one, help the government maintain aggregate supply levels (price of goods and services) and two, support asset prices in order to prevent any further deflationary erosion ( Like Realestate). So in the Feds calculations if you stabilize aggregate supply levels and prevent erosion of assets values you in turn would create an economic recovery, right?! WRONG!!!

    Now follow closely to what I am about to say. We have never recovered from the September 2008 crash. All this talk about a “double dip” is a moot point as we never clawed our way from the first dip. The economy is as it has been for the last two years; heading down, no matter what all the talking heads on radio and TV say. For you see in trying to perform the same techniques which were applied with the crash of 1929 and 1933; the Fed has exhausted its cache of stimulus tools. They have done nothing and they have nothing left. After pumping trillions into stimulus plans, and trillions to improve balance sheets of the “Too Big to Fail” banks they have accomplished one thing; they have UNDERMINED TREASURIES!!!

    Treasuries are the very threads that is holding this economy together and now these policies have metamorphosed them into the NEW AND IMPROVED TOXIC ASSET!!! Every world economy knows that they are overvalued, they know that their yields are mediocre and still no one in the main stream talking head shows ever rails against or even exposes them. The whole world cart blanche walks on eggshells around treasuries as if it were a Financial Nuke with a trip wire trigger and a timer. A bomb if you will….which IT IS.

    History shows us a pattern when and how this financial Hiroshima goes off. It begins like this:

    There will be a slight and sudden rise in a price of a necessary commodity like Oil

    This will send tremors through the treasury yields, Treasury Mangers will sell off their allocations and go into the commodity (e.g. Oil) in order to grab a profit. I guarantee that they will sell treasuries as it’s the primary asset that many of them can sell.

    This will trigger the Fed to step in and buy the dumped Treasuries as they are trying to stave off deflation by keeping low yields and cheaply funded. (Quantative Easing) The Fed knows that the Bond Market senses a “Treasury Bubble” and once again they turn on the printing press to buy every treasury in sight to calm the markets and create asset price stability

    The Zombie “Too Big to Fail” Banksters smell blood in the water and begin to dump their obscene amount of treasury notes. You see these living dead institutions were never nationalized but got the best parts of nationalization; total liquidity (stimulus money) and easing of accounting and regulatory rules. The flip side was the Fed required that they purchase US treasuries. You see buying up of the treasuries allowed their balance sheets to look well funded and monetized, all the while hiding the toxic assets that were being siphoned off their books by the Fed since 2008.

    The Panic sets in…Asset managers are not stupid they know the US is in much worse shape than Greece. They know that there is a “Treasury Bubble”. So when these mangers see the mass buying of treasuries by the Fed, and the mass dumping by the Zombie Banks, it will be their signal to get out of Dodge!!!

    The Zombie To Big To Fails and Asset Managers that have dumped their toxic treasuries will look for a place to park their new found cash. Now where might you think they can put all that new cash into? COMMODITIES. Commodities of all types will shoot to the moon. From precious and industrial metals, Oil, food staples will all skyrocket in price, catching the American public with their pants down. Commodities will be the only safe haven to go to and this is when the American public will get it’s first taste of hyperinflation and it will taste like gasoline when the price of oil surges passed $150 a barrel in one week equating to $10 a gallon gas!!!

    Commodities SOARS and DOLLAR COLLAPSE ensues. The sell off of assets in purchase of commodities will be ballistic. People will unload homes, cars, personal belongings all once thought important for real assets like Gold, Silver, Food, Weapons, and Oil. In hyperinflation your $400,000 house will be worth $60,000 or 70 pieces of silver, for your house will not be able to help you buy things you need, while a commodity like gold and silver can.

    Most of all the government can’t stop it.

  • jess Liver. More

    gd. item
    “Hungary nat’ ized retirement accts, Argen., Ire. consider doing same.”
    + “100,000+ protest on London strs., UK, 3/11 against austerity,”
    more ordered for Port. (p minster / gov falls).

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