Within minutes, the yield on the 10-year US treasury note had plummeted 50 basis points, the most in 45 years.
And why not? The Federal Reserve announced last week that it would be purchasing as much as $300 billion (Rs15.15 trillion today) of longer-term treasury securities over the next six months, along with $1.25 billion of agency mortgage-backed securities (MBS) and $200 billion of agency debt this year.
There’s only one problem: If Fed chief Ben Bernanke is successful in his commitment to preventing deflation at any cost, buying 10-year treasuries at 2.5% will turn out to be a losing proposition for investors.
Why? Real 10-year yields, as reflected in inflation-indexed treasurys (TIPS or treasury inflation protected securities), are currently at 1.38%. That’s below the historical average of 1.8% since the creation of the Federal Reserve in 1913, according to Jim Bianco, president of Bianco Research in Chicago. (Can you guess whether real rates were higher or lower before the US had a central bank?)
Take out the World War II period, when the Fed pegged long-term rates to help the treasury’s war effort, and the average is probably closer to 2-2.5%, according to Bill Poole, former president of the St Louis Fed and now a Bloomberg contributor.
Based on my admittedly unsophisticated math—subtracting 10-year TIPS yields from 10-year nominal treasury yields—expected inflation is 1.24% over the next 10 years. (Second quiz question: What are the chances of inflation being that tame with the Fed pulling out all the stops?)
In other words, there’s no real return on 10-year notes at this level, Poole says.Economists see the Fed’s balance sheet ballooning to $4.5 trillion this year, with its announced purchases added to existing lending facilities. That’s trillion with a T. And it would be five times the size of the balance sheet in the first eight months of 2008, before the Fed cranked up the printing presses.
In the short run, bond traders will capitalize from a price-insensitive buyer waiting in the wings. They want to buy now, push the price higher, and then sell it at the offered side to the Fed, Bianco says. Once that’s done, you want to sell everything you own and run, not walk, away from the market, he says.
Poole compares the current situation to 2003, when investors believed the Fed would ensure yields went only in one direction: down.
At some point, the Fed will have to reverse course and start shrinking its balance sheet. By that time, those 2.5% 10-year notes may be trading at 4%, delivering losses to all but the most nimble.
What will change the one-way bet on rates? Maybe it will be a faint sign of stirring in some piece of economic data, a report that isn’t quite as bad as the previous month’s. Or else it could be a turn up in leading indicators, which most folks ignore even though they’re called leaders for a reason.
Perhaps it will be a decline in the dollar or a whiff of inflation, rearing its ugly head even with gobs of slack in labour and product markets. When that happens, the market will part ways with the Fed. The Fed will have to part ways with wishes of the US Congress and start unwinding its balance sheet when the unemployment rate, a lagging indicator, is uncomfortably high.
The Fed has committed to buy $1.25 trillion of MBSs, which it expects to hold to maturity, $200 billion of agency debt and $300 billion of treasuries. That builds a lot of inflexibility into the balance sheet, of an institution that wants to maintain flexibility when it comes to policy, Poole says.
Poole, for one, thinks the balance sheet expansion already in place—banks are holding $622 billion of excess reserves, based on the latest Fed data—is already enough. Anything more is pouring fuel into a fire box, he says.
I’m sure Bernanke is aware of the challenge of getting the timing of the Fed’s exit strategy right. Anyone who watched his 15 March 60 Minutes interview came away with the impression that Bernanke is one smart, competent, confident and committed Fed chairman.
In that interview, he said the biggest risk to recovery is the lack of political will. I suspect he was referring to Congress, says Jim Glassman, senior US economist at JPMorgan Chase and Co.
Bernanke is the only adult in Washington right now. Members of Congress, who are doing their best to make the Keystone Cops look professional, interpreted public outrage at the $165 million in American International Group Inc.’s bonuses as licence to waste their time and our money on a witch hunt. President Barack Obama let himself get sucked into the child’s play, asking his minions to find a legal way to abrogate the contracts. That’s not the way to inspire confidence among our counterparties around the globe.
And treasury secretary Timothy Geithner, who was damaged goods to start because of the imbroglio over his tax returns, has been voted the most likely fall guy when the fallout from the bank bailouts and fiscal stimulus gets too hot.
That leaves us with Bernanke running the show. If anyone can succeed, he can. The irony is that success in averting deflation guarantees losses to buyers of 10-year treasury notes at current yields. Which brings us to the last question of the quiz: Do you expect the Fed to be early or late in reversing course? BLOOMBERG
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