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Now Start Watching Interest Rates, Part 3

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.

 

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