The Fed Steps Away from US Treasuries.

The Fed would have us believe that the total size of its holdings of US Treasuries is what matters in its effort to keep US rates low across the yield curve.  I beg to differ.

Due to the US budget deficit and existing Treasury debt which matures every year, there is a huge supply of US Treasuries for which buyers need to be found every year.  I just don’t buy the Fed’s argument that the size of their existing holding is what matters in keeping the yield curve low. 

Every trader knows that it is the marginal buyer which sets the price at which a liquid asset trades at. The Fed has recently been buying $45 bln of Treasuries every month. The Fed can sit tight on its stock of XX% of US Treasuries but if the bond market decides in its collective wisdom that they are going to charge the US government 4% to borrow money for 10 years then that is where 10-year yields are going to go.  No amount of squealing by an existing large holder is going to stop fresh 10-year US Treasuries from being sold at whatever yield bond investors deem appropriate.  When you borrow as much as the US you have to pay the interest rate your lenders decide to charge. 

The real explanation for why the US yield curve continues to price 10-year yields at 1.xx% is because the Fed has promised to keep interest rates at zero until mid-2015.  This has compressed the front end of the yield curve and low forward rates have had an impact further out along the yield curve.

This is the real genius behind the Fed extracting itself from buying US Treasury bonds without causing a market collapse.  First they announced Operation Twist, reinvesting the proceeds of sales of short-dated bonds into longer-term bonds.  Then they extended the program until end-2012.  Then they muddied the water by announcing QE-Infinity, the purchase of $40 bln of agency MBS for as long as it takes the unemployment rate to come down in a serious fashion.  At the same time they “promise” the markets they will not raise rates once the economy gains serious traction but will keep them at zero until at least mid-2015.  The net effect is a huge buyer of Treasuries will stop buying at the end of this month and the market has been fooled into keeping 10-year yields below 2% by a “promise” that the Fed wont raise rates for at least a couple more years.

The age-old rule in the bond markets is that yields back up smartly once the participants scent economic recovery.  Players buying 10-year bonds yielding less than 2% in the face of economic recovery are asking for trouble.  The only thing keeping bond prices up is a promise from the Fed – once the market realises it has been fooled then the backup in bond yields will make 1994 look like a tea party.  The Fed can afford to hold its Treasuries until they mature whilst it watches the bond market puke.

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