These days, The Federal Reserve Bank seems to have very few supporters. A recent poll showed that “Twenty-six percent of Americans said they were ‘a lot less’ confident in the Fed…now than five years ago.” Some people think the Fed is doing too much in responding to the economic downturn, others accuse it of doing too little, and everyone agrees the Fed is culpable for lax regulatory efforts under Alan Greenspan. One of the biggest criticisms being levied at the Fed is that its current policies are sure to generate massive inflation in the medium-term, as a result of the massive liquidity being pumped into the financial system now. In this post, I will attempt to provide some clarity on this aspect.
Sure enough, the US monetary base (represented by M1) has exploded since the inception of the credit crisis, rising more than 15% to more than $1.5 Trillion. Plus, given that there is a slight lag in the release of data, these figures don’t necessarily include the effects of the Fed’s expansion in its quantitative easing program, announced on March 18. One commentator explains that, “Of all the Fed’s moves, this ‘quantitative easing’ gets money into the economy the fastest — basically by cranking the handle of the printing press and flooding the market with dollars (in reality, with additional bank credit). Since these dollars are not going into home building, coal-fired electric plants or auto factories, they end up in the stock market.” In the short-term, then, QE has probably contributed only to asset-price inflation, rather than the more serious consumer price inflation.
What about the charge that the Fed is dangerously reaching its tentacles into every corner of the financial markets? As you can see from the chart below, there is certainly a huge degree of truth to this claim. Since January 2008, the Fed has “diversified” its portfolio away from relatively benign Treasury securities, into at least 20 different types of securities and loans. In the process, its balance sheet exploded from approximately $800 Billion to $2.2 Trillion, and could expand further as the next phase of quantitative easing is implemented.
This portfolio’s makeup is indeed becoming increasingly risky. For example, “The Federal Reserve took on more than $74 billion in subprime mortgages, depreciating commercial leases and other assets after Bear Stearns Cos. and American International Group Inc. collapsed.” Despite writing down almost $10 Billion from this portion alone, however, the Fed continues to turn consistent profits. “Last year the central bank reported a whopping $43 billion in operating income. That was more or less the same level as in 2007, but meanwhile short-term interest rates had plummeted, ending the year near zero.” The assertions of conspiracy theorists, notwithstanding, the majority of this profit was transferred to the US Treasury. [Chart courtesy of The Economist].
Fortunately, most of the (non-esoteric) securities are highly liquid, and can theoretically be sold to investors if and when it becomes appropriate to do so. “The Fed, for example, is required by law to end some when the need is no longer urgent. It charges a penalty for some programmes so that borrowers will return to private markets once these have healed.” The Commercial Paper Funding Facility (CPFF) and Term Auction Facility (TAF) programs, which together account for over $650 Billion of the Fed’s portfolio, moreover, can be quickly undone. “The maturity of the outstanding [TAF] loans is 84 days at a maximum, ” while CPPF “deals in short-term money market instruments and can also be phased out, if desired, in a short period of time.”
The $400 Billion in swap lines, on the other hand, are slightly more problematic, both because of the longer time frame and because foreign banks “are now heavily dependent on the Fed for dollars.” Then there is the Term Asset-Backed Securities Loan Facility (TALF), which is not yet operational. While this program is also designed to be temporary, “the multi-year maturities of the loans and the potential size of the program—up to $1 trillion—make the impact on the monetary base more persistent than for some of the other liquidity programs.”
In short, inflation isn’t yet on the radar screen, as economists and bankers must first combat disinflation, and perhaps even deflation. Of course, there is always the (very serious) risk that the Fed either won’t be able to, or simply won’t be diligent enough in removing this cash from the money supply when the time comes. There is also a moral hazard component of the Fed’s QE, whereby “governments could come to rely on such purchases to finance budget deficits.” In my opinion, this kind of scenario would be much more likely to engender inflation, but it would be primarily the fault of the government (as opposed to the Fed), and hence beyond the scope of this post.
Sure enough, the US monetary base (represented by M1) has exploded since the inception of the credit crisis, rising more than 15% to more than $1.5 Trillion. Plus, given that there is a slight lag in the release of data, these figures don’t necessarily include the effects of the Fed’s expansion in its quantitative easing program, announced on March 18. One commentator explains that, “Of all the Fed’s moves, this ‘quantitative easing’ gets money into the economy the fastest — basically by cranking the handle of the printing press and flooding the market with dollars (in reality, with additional bank credit). Since these dollars are not going into home building, coal-fired electric plants or auto factories, they end up in the stock market.” In the short-term, then, QE has probably contributed only to asset-price inflation, rather than the more serious consumer price inflation.
This portfolio’s makeup is indeed becoming increasingly risky. For example, “The Federal Reserve took on more than $74 billion in subprime mortgages, depreciating commercial leases and other assets after Bear Stearns Cos. and American International Group Inc. collapsed.” Despite writing down almost $10 Billion from this portion alone, however, the Fed continues to turn consistent profits. “Last year the central bank reported a whopping $43 billion in operating income. That was more or less the same level as in 2007, but meanwhile short-term interest rates had plummeted, ending the year near zero.” The assertions of conspiracy theorists, notwithstanding, the majority of this profit was transferred to the US Treasury. [Chart courtesy of The Economist].
Fortunately, most of the (non-esoteric) securities are highly liquid, and can theoretically be sold to investors if and when it becomes appropriate to do so. “The Fed, for example, is required by law to end some when the need is no longer urgent. It charges a penalty for some programmes so that borrowers will return to private markets once these have healed.” The Commercial Paper Funding Facility (CPFF) and Term Auction Facility (TAF) programs, which together account for over $650 Billion of the Fed’s portfolio, moreover, can be quickly undone. “The maturity of the outstanding [TAF] loans is 84 days at a maximum, ” while CPPF “deals in short-term money market instruments and can also be phased out, if desired, in a short period of time.”
The $400 Billion in swap lines, on the other hand, are slightly more problematic, both because of the longer time frame and because foreign banks “are now heavily dependent on the Fed for dollars.” Then there is the Term Asset-Backed Securities Loan Facility (TALF), which is not yet operational. While this program is also designed to be temporary, “the multi-year maturities of the loans and the potential size of the program—up to $1 trillion—make the impact on the monetary base more persistent than for some of the other liquidity programs.”
In short, inflation isn’t yet on the radar screen, as economists and bankers must first combat disinflation, and perhaps even deflation. Of course, there is always the (very serious) risk that the Fed either won’t be able to, or simply won’t be diligent enough in removing this cash from the money supply when the time comes. There is also a moral hazard component of the Fed’s QE, whereby “governments could come to rely on such purchases to finance budget deficits.” In my opinion, this kind of scenario would be much more likely to engender inflation, but it would be primarily the fault of the government (as opposed to the Fed), and hence beyond the scope of this post.
Pound Sterling Trends Downward as BOE Expands QE
The Pound is holding its own against the USD, even touching a four-month high last week. But against other major currencies, the story is just the opposite. While managing to avoid parity against the Euro, for example, the Pound has nonetheless remained range-bound against the common currency. The Australian Dollar, meanwhile, has risen to $2 against the Pound for the first time in 13 years.
How to explain the stagnation of the Pound? It depends on which currency pair you look at. Against the Dollar, the narrative remains one of risk aversion; when stocks rise, so usually does the Pound. “The U.K. pound is joining other currencies in beating up on the dollar,” announced one analyst on a day that stocks and commodities rallied broadly. The Pound has also been able to hold its own against the Dollar because both currencies’ Central banks have embarked on similar quantitative easing plans, which could prove equally inflationary in the long run. [Chart courtesy of Economist].
In fact, the Bank of England just announced a huge expansion in its program, increasing total debt buying (i.e. money printing) by $50 Billion. One analyst summarized the impact of this announcement on forex markets as follows: “The Bank of England’s aggressive stance with regard to quantitative easing is adding to concern about the economy and that is negative for sterling.” Not much nuance there….
In fact, this is especially bad for the Pound against the Euro, where a juxtaposition of the Central Banks’ respective approaches to the credit crisis reveals stark differences: “The weakness in the pound suggests the market is drawing a contrast between the ECB, which seems to be dragging its legs on quantitative easing, and the BOE, which is still ‘full-steam ahead.’ ” Where the ECB is providing liquidity indirectly in the form of swaps and guarantees, the BOE is printing money and injecting it right into capital markets.
“Mervyn King, governor of the Bank of England, has said the exit strategy will be dictated by the outlook for inflation and that central banks should not support markets that cannot survive on their own,” but investors remain skeptical and for good reason. “Britain will sell a record 220 billion pounds of gilts this fiscal year, 50 percent more than last year.” Based on the fact that yields have risen for four straight weeks (against the backdrop of the first “failed” auction ever for UK government bonds), there is doubt that the government can finance its deficits.
The BOE continues to be roundly smacked with criticism, for its role in fomenting the credit crisis and in not adequately responding to it: “It happens that in the early years of inflation targeting, it did produce a stable economy. But I think it’s now clear that it can’t, by itself, produce a stable economy,” argued one commentator. Unemployment rates in the UK remain at frighteningly high levels. The government’s own economists (which are more optimistic than third-party forecasts) forecast GDP at -3.5% for 2009, with a modest recovery in 2010. Of course, these forecasts should be taken with a grain of salt, as they hinge on the crucial assumption that the BOE’s interest rate cuts and quantitative easing plan will soon trickle down through the economy, proof of which has still not been observed.
As a result, I’m personally between neutral and bearish for the UK Pound. For as long as stocks continue to rally, investors will remain Adistracted. If and when the rally loses steam (I am skeptical that the rally is sustainable), they will quickly turn their attention to comparative economic and monetary conditions; suffice it to say that Pound won’t stack up well.
How to explain the stagnation of the Pound? It depends on which currency pair you look at. Against the Dollar, the narrative remains one of risk aversion; when stocks rise, so usually does the Pound. “The U.K. pound is joining other currencies in beating up on the dollar,” announced one analyst on a day that stocks and commodities rallied broadly. The Pound has also been able to hold its own against the Dollar because both currencies’ Central banks have embarked on similar quantitative easing plans, which could prove equally inflationary in the long run. [Chart courtesy of Economist].
In fact, the Bank of England just announced a huge expansion in its program, increasing total debt buying (i.e. money printing) by $50 Billion. One analyst summarized the impact of this announcement on forex markets as follows: “The Bank of England’s aggressive stance with regard to quantitative easing is adding to concern about the economy and that is negative for sterling.” Not much nuance there….In fact, this is especially bad for the Pound against the Euro, where a juxtaposition of the Central Banks’ respective approaches to the credit crisis reveals stark differences: “The weakness in the pound suggests the market is drawing a contrast between the ECB, which seems to be dragging its legs on quantitative easing, and the BOE, which is still ‘full-steam ahead.’ ” Where the ECB is providing liquidity indirectly in the form of swaps and guarantees, the BOE is printing money and injecting it right into capital markets.
“Mervyn King, governor of the Bank of England, has said the exit strategy will be dictated by the outlook for inflation and that central banks should not support markets that cannot survive on their own,” but investors remain skeptical and for good reason. “Britain will sell a record 220 billion pounds of gilts this fiscal year, 50 percent more than last year.” Based on the fact that yields have risen for four straight weeks (against the backdrop of the first “failed” auction ever for UK government bonds), there is doubt that the government can finance its deficits.
The BOE continues to be roundly smacked with criticism, for its role in fomenting the credit crisis and in not adequately responding to it: “It happens that in the early years of inflation targeting, it did produce a stable economy. But I think it’s now clear that it can’t, by itself, produce a stable economy,” argued one commentator. Unemployment rates in the UK remain at frighteningly high levels. The government’s own economists (which are more optimistic than third-party forecasts) forecast GDP at -3.5% for 2009, with a modest recovery in 2010. Of course, these forecasts should be taken with a grain of salt, as they hinge on the crucial assumption that the BOE’s interest rate cuts and quantitative easing plan will soon trickle down through the economy, proof of which has still not been observed.
As a result, I’m personally between neutral and bearish for the UK Pound. For as long as stocks continue to rally, investors will remain Adistracted. If and when the rally loses steam (I am skeptical that the rally is sustainable), they will quickly turn their attention to comparative economic and monetary conditions; suffice it to say that Pound won’t stack up well.
Swiss National Bank Renews Threat of Intervention
When the Swiss National Bank (SNB) announced oln March 12 that it would intervene in forex markets for the first time since 1994, the Franc immediately plummeted up to 5% against select currencies. Since then, the currency has largely clawed back some of its losses, prompting talk of round two: “Speculation about an imminent intervention in the foreign-exchange markets was rife…after the euro fell to CHF1.5031, the lowest level seen since March 12 when the SNB began selling Swiss francs against euros.”
It was unclear whether the Central Bank had chosen a magic threshold, such that a rise by the Franc above which would trigger a sale of Francs in the open market. Earlier in the week, one analyst asserted, “With the euro/franc exchange rate almost at pre-intervention levels – the euro jumped to a level above CHF1.52 after the SNB intervention in March from CHF1.4843 before the announcement – the stage is set for the SNB to either put up or shut up.”
Sure enough, both the Chairman of the SNB as well as a board member both announced yesterday that the campaign to hold down the the Franc is still in effect, and will soon enter a new phase. Thus far, the Bank has relied on various forms of quantitative easing to deflate its currency, both through direct currency transactions and purchases of bonds. The goal of such quantitative easing is only proximately to deflate the Franc; the ultimate goal is to ward off deflation. Given that the Bank had already lowered its benchmark interest rate close to zero, manipulating its currency was/is one of its few remaining options. “As long as the environment does not improve and as long as deflation risks are visible in our monetary policy concept, we will stick to this insurance strategy resolutely,” said Chairman Jean-Pierre Roth.
As the economic recession takes hold, the Swiss economy is forecast to contract 3% in 2009, but to grow in 2010. Consumer sentiment has fallen to the lowest level since 2003. Inflation, meanwhile is projected at -0.5%; deflation, in other words. Still, Switzerland maintains that its motivation is not to boost the economy, but only to increase monetary stability. National Bank governing board member Thomas Jordan “reiterated the interventions have nothing to do with a beggar-thy-neighbor policy, a strategy to weaken a country’s currency to improve the situation for domestic exporters.”
Given that forex intervention is usually doomed to failure, the SNB must rely on a combination of luck and improved fundamentals to keep the Franc down. Thus, when the next round of intervention was announced yesterday, the Franc fell by a modest .75% against the Euro, as investors largely shrugged of the news. Fortunately, the initial pledge to intervene coincided with a pickup in investor sentiment, and decline in risk aversion. This has reduced demand for the Swiss Franc, which had previously been bid up as a so-called “safe haven” currency. As long as the stock market rally continues, investors will stick to higher-yielding currencies and the Franc should be “safe.”
It was unclear whether the Central Bank had chosen a magic threshold, such that a rise by the Franc above which would trigger a sale of Francs in the open market. Earlier in the week, one analyst asserted, “With the euro/franc exchange rate almost at pre-intervention levels – the euro jumped to a level above CHF1.52 after the SNB intervention in March from CHF1.4843 before the announcement – the stage is set for the SNB to either put up or shut up.”Sure enough, both the Chairman of the SNB as well as a board member both announced yesterday that the campaign to hold down the the Franc is still in effect, and will soon enter a new phase. Thus far, the Bank has relied on various forms of quantitative easing to deflate its currency, both through direct currency transactions and purchases of bonds. The goal of such quantitative easing is only proximately to deflate the Franc; the ultimate goal is to ward off deflation. Given that the Bank had already lowered its benchmark interest rate close to zero, manipulating its currency was/is one of its few remaining options. “As long as the environment does not improve and as long as deflation risks are visible in our monetary policy concept, we will stick to this insurance strategy resolutely,” said Chairman Jean-Pierre Roth.
As the economic recession takes hold, the Swiss economy is forecast to contract 3% in 2009, but to grow in 2010. Consumer sentiment has fallen to the lowest level since 2003. Inflation, meanwhile is projected at -0.5%; deflation, in other words. Still, Switzerland maintains that its motivation is not to boost the economy, but only to increase monetary stability. National Bank governing board member Thomas Jordan “reiterated the interventions have nothing to do with a beggar-thy-neighbor policy, a strategy to weaken a country’s currency to improve the situation for domestic exporters.”
Given that forex intervention is usually doomed to failure, the SNB must rely on a combination of luck and improved fundamentals to keep the Franc down. Thus, when the next round of intervention was announced yesterday, the Franc fell by a modest .75% against the Euro, as investors largely shrugged of the news. Fortunately, the initial pledge to intervene coincided with a pickup in investor sentiment, and decline in risk aversion. This has reduced demand for the Swiss Franc, which had previously been bid up as a so-called “safe haven” currency. As long as the stock market rally continues, investors will stick to higher-yielding currencies and the Franc should be “safe.”
Despite “Reality,” Fed Optimistic about the Economy
Last week, the Fed opted to maintain its benchmark Federal Funds Rate close to zero, and indicated in its press release that it “anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” [Chart courtesy of CNN].
Nonetheless, the Fed made a point of emphasizing that the economy seems to be stabilizing: “Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract, though the pace of contraction appears to be somewhat slower.” I suppose everything is relative, but it’s a bit perplexing as to where the Fed is getting its data from, given that “Gross domestic product, the broadest measure of economic activity, fell at an annual rate of 6.1% in the first quarter of 2009 after a 6.3% drop in the last three months of 2008.” This exceeded analysts’ expectations for a 4.7% decline, and if anything, would seem to suggest that the economy is worsening. Granted, consumer spending rose slightly and inventories declined, but the aggregate picture paints an unequivocal picture of an economy in deep recession.
Bernanke, apparently, is unconvinced. ” ‘We continue to expect economic activity to bottom out, then to turn up later this year,’ Mr. Bernanke told the congressional Joint Economic Committee.” Meanwhile, the unemployment rate is currently 8.5% and falling. Business investment is still abysmal, as companies implement hiring freezes and hold off on all non-essential capital purchases.
Bernanke is especially optimistic about the state of the US financial system, noting that “conditions in credit markets have revived slightly in recent weeks. Homeowners are refinancing mortgages at a rapid clip, and financial institutions have stepped up their sale of securities backed by of credit card loans, automobile debt and student loans.” However, mortgage refinancing is a red herring, and frees up very little cash for consumption. Meanwhile, debt securitization is well below 2007 levels, and some experts predict that credit card loans represent the next catastrophe. “Fitch’s Prime Credit Card Delinquency Index measures credit card debt more than 60 days late. Through January 2009 that index surged to a record 4.04 percent.”
Bernanke also hinted that the results from the bank stress-tests, scheduled to be released today, are largely positive. As part of this program, “The government plans to divide banks into three categories, based on the adequacy of their capital reserves to absorb projected losses,” if the recession were to worsen. If Bernanke’s assertions are to be believed, then the tests will show that their capital reserves are sufficient, and they will not need additional capital infusions.
Bernanke’s testimony and the Fed Statement have been greeted positively by investors, “contributed to improving sentiment and boosted risk appetite, easing demand for then yen and greenback as safehavens.” Nonetheless, everything he says should be taken with a grain of salt. Even with the best rose-tinted glasses money can buy, it’s hard to draw such optimistic conclusions from an objective interpretation of the data. Either Bernanke is basing his assessment off of the stock market rally (which is circularly based on such economic optimism), or he is trying to deliberately distort reality in order to try to make a recovery self-fulfilling by disingenuously telling people that everything is okay. Personally, I don’t think he’s worth taking seriously.
Nonetheless, the Fed made a point of emphasizing that the economy seems to be stabilizing: “Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract, though the pace of contraction appears to be somewhat slower.” I suppose everything is relative, but it’s a bit perplexing as to where the Fed is getting its data from, given that “Gross domestic product, the broadest measure of economic activity, fell at an annual rate of 6.1% in the first quarter of 2009 after a 6.3% drop in the last three months of 2008.” This exceeded analysts’ expectations for a 4.7% decline, and if anything, would seem to suggest that the economy is worsening. Granted, consumer spending rose slightly and inventories declined, but the aggregate picture paints an unequivocal picture of an economy in deep recession.Bernanke, apparently, is unconvinced. ” ‘We continue to expect economic activity to bottom out, then to turn up later this year,’ Mr. Bernanke told the congressional Joint Economic Committee.” Meanwhile, the unemployment rate is currently 8.5% and falling. Business investment is still abysmal, as companies implement hiring freezes and hold off on all non-essential capital purchases.
Bernanke is especially optimistic about the state of the US financial system, noting that “conditions in credit markets have revived slightly in recent weeks. Homeowners are refinancing mortgages at a rapid clip, and financial institutions have stepped up their sale of securities backed by of credit card loans, automobile debt and student loans.” However, mortgage refinancing is a red herring, and frees up very little cash for consumption. Meanwhile, debt securitization is well below 2007 levels, and some experts predict that credit card loans represent the next catastrophe. “Fitch’s Prime Credit Card Delinquency Index measures credit card debt more than 60 days late. Through January 2009 that index surged to a record 4.04 percent.”
Bernanke also hinted that the results from the bank stress-tests, scheduled to be released today, are largely positive. As part of this program, “The government plans to divide banks into three categories, based on the adequacy of their capital reserves to absorb projected losses,” if the recession were to worsen. If Bernanke’s assertions are to be believed, then the tests will show that their capital reserves are sufficient, and they will not need additional capital infusions.
Bernanke’s testimony and the Fed Statement have been greeted positively by investors, “contributed to improving sentiment and boosted risk appetite, easing demand for then yen and greenback as safehavens.” Nonetheless, everything he says should be taken with a grain of salt. Even with the best rose-tinted glasses money can buy, it’s hard to draw such optimistic conclusions from an objective interpretation of the data. Either Bernanke is basing his assessment off of the stock market rally (which is circularly based on such economic optimism), or he is trying to deliberately distort reality in order to try to make a recovery self-fulfilling by disingenuously telling people that everything is okay. Personally, I don’t think he’s worth taking seriously.
Spike in Treasury Yields is Good News for US Dollar Bulls
By no coincidence, the Dollar’s best day in April was a mirror image of its worst day in March. Recall what happened when the Fed initially announced its quantitative easing program: “The dollar plunged a record 3.4 percent against the euro on March 18 as traders speculated the Fed’s purchase Treasuries would debase the currency.” On April 29, meanwhile, “The dollar rose the most against the yen this month after the Federal Reserve refrained from increasing purchases of Treasuries and mortgage securities.”
The implication is that as risk aversion has dropped, investors have turned their gaze towards interest rates. Previously, this phenomenon would have worked against the Dollar, as both short-term and long-term interest rates are generally lower in the the US than they are abroad. On the short end of the curve, this is a product of a low Federal Funds Rate, as guided by the Fed. On the long end, this is a function of high demand for US Treasury securities, which keeps prices high and rates proportionately low.
However, this trend is very quickly reversing itself. Aside from a few hiccups (including a big one on March 18!), Treasury yields have risen continuously since touching an all-time low in January. Since then, the yield on the 10-year note, for example, has risen from 2.2% to nearly 3.2%. The impetus for higher rates is coming both from a decline in risk aversion (which is leading investors to seek alternatives to Treasuries) as well as a concern that the Fed will not be as active in buying US bonds as it had initially intimated.
A decline in demand for Treasury securities is making some investors understandably nervous that the government will not be able to fund its deficits (projected at 10% of GDP in 2009). Writes one columnist, “We cannot take it for granted that the global bond markets will prove deep enough to fund the $6 trillion or so needed for the Obama fiscal package, US-European bank bailouts, and ballooning deficits almost everywhere.” The fear is that the government will turn to the Fed, which will stoke inflation by printing money, and induce a devaluation of the Dollar.
If the Fed limits its purchase of Treasuries, by extension, not only will this limit inflation, but also it will lead to higher interest rates on US government bonds, which should help prop up investor demand. One currency strategist observed that “The dollar-yen is very closely correlated with the back end of the yield spread.” In other words, as US long-term yields rise, so may the Dollar.
Of course, the key is to strike a balance between too much demand and not enough. If investors got really spooked by the fact that “The Congressional Budget Office expects interest payments to more than quadruple in the next decade as Washington borrows and spends, to $806 billion by 2019 from $172 billion next year,” then it could lead to a skyrocketing of interest rates as investors beat a mass retreat away from Treasuries, which would certainly entail a devaluation of the Dollar. To apply Alan Greenspan’s famous analogy, has anyone coined the term “Goldilocks Treasury Yields” yet?
The implication is that as risk aversion has dropped, investors have turned their gaze towards interest rates. Previously, this phenomenon would have worked against the Dollar, as both short-term and long-term interest rates are generally lower in the the US than they are abroad. On the short end of the curve, this is a product of a low Federal Funds Rate, as guided by the Fed. On the long end, this is a function of high demand for US Treasury securities, which keeps prices high and rates proportionately low.
However, this trend is very quickly reversing itself. Aside from a few hiccups (including a big one on March 18!), Treasury yields have risen continuously since touching an all-time low in January. Since then, the yield on the 10-year note, for example, has risen from 2.2% to nearly 3.2%. The impetus for higher rates is coming both from a decline in risk aversion (which is leading investors to seek alternatives to Treasuries) as well as a concern that the Fed will not be as active in buying US bonds as it had initially intimated.
If the Fed limits its purchase of Treasuries, by extension, not only will this limit inflation, but also it will lead to higher interest rates on US government bonds, which should help prop up investor demand. One currency strategist observed that “The dollar-yen is very closely correlated with the back end of the yield spread.” In other words, as US long-term yields rise, so may the Dollar.
Of course, the key is to strike a balance between too much demand and not enough. If investors got really spooked by the fact that “The Congressional Budget Office expects interest payments to more than quadruple in the next decade as Washington borrows and spends, to $806 billion by 2019 from $172 billion next year,” then it could lead to a skyrocketing of interest rates as investors beat a mass retreat away from Treasuries, which would certainly entail a devaluation of the Dollar. To apply Alan Greenspan’s famous analogy, has anyone coined the term “Goldilocks Treasury Yields” yet?
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