Will the Fed Target Long-Term Rates?

There was a lot of news to write about on Monday…Seriously.

Besides Arnie calling California’s situation “a fiscal emergency”, the Dow crashing 680 points, more Goldman bonus cuts, Oil falling below $50…oh, and of course. It’s finally an official recession. However some of the biggest news comes from the FED concerning alternative measures to adding liquidity to the markets.

When the FOMC “cuts” interest rates, it does so by buying short-term treasury bills. This method of adding liquidity into the economy is hampered if there is no interest rate to “cut”.

COUPON	MATURITY DATE	CURRENT PRICE/YIELD	PRICE/YIELD CHANGE	TIME
3-Month	0.000	03/05/2009	0.04 / .04	0 / .000
6-Month	0.000	06/04/2009	0.32 / .44	-0.1 / -.102

This pickle we find ourselves in is known as a “liquidity trap”, where virtually all of the government’s supply of T-bills have been met with excessive demand (in this case, this is the quantification of a flight to safety).

What really set the markets off yesterday (at least the bond market) was something Ben Bernanke mentioned in a Q & A held in Austin, Texas; when confronted with this very issue of a liquidity trap, he pointed out that the FED was not constrained to traditional metrics of expanding the money supply, but referenced a speech he delivered back in 2002, the last time the U.S. went through a deflation scare - one in which, like today, we straddled very low inflation coupled with the fear of slowing aggregate demand. Here are some excerpts from his 2002 speech:

Deflation is in almost all cases a side effect of a collapse of aggregate demand–a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.

Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has “run out of ammunition”–that is, it no longer has the power to expand aggregate demand and hence economic activity.

Just to keep things in perspective with the crash of 1987….yesterday’s drop wasn’t THAT bad.

10-Year Note, 1-Month Timeframe

10-Year Note, 1-Month Time Frame: 10/16/87 - 11/16/87

Now it was this idea, his non-traditional method of providing liquidity in a ZIRP environment, where the yields on 10-year notes began to tank:

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities.

A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields.

Keep in mind that the above quoted section is from 2002, not today…though it’s funny how relevant it is.

It’s also interesting how the bond market reacted like this was some sort of new idea; Bernanke has always maintained the reputation of being an expert on the Great Depression, and his ideas for monetary policy in a zero-interest-rate environment have been public for quite some time (6 years, to be exact…I suppose the efficient markets hypothesis has selective cognition).

Either way, this would be a ground breaking policy: Bernanke’s mention of the strategy in his speech today pushed the yield on 10-year Treasuries down 22 basis points and the 10-year’s yield to 2.70%, its lowest since 1955.

Disclosure: Long PST.

Comments

[Zee4Money:]

This is exactly what the economy needs to stabilize housing prices. Lower long-term yields should lead to lower mortgage rates, when combined with the Fed’s buying of mortgage-backed securities.

2008 Dec 03 08:32 AM

[tnk4800:]

what the fed needs to do is get banks out of the mortgage business immediately. Cut the mortgage lenders out.They proved once again they are thieves.
Loan directly to buyers and people who need to re-finance. Charge a simple 2% for a 30 year Home loan add 1% for insurance to guarantee the loan. FMA and Freddy adminsitrate or subcontract it out to banks and insurers.
Residence only, one home, fed originated, transparent, administraighted, guaranteed loan per buyer . They could establish another level for investors, multiple property buyers say 4% plus 1/2 % to guarantee the loan.
Defaults if any would be held and administrated by the fed, setting a minimum auction price to stabilyze the market.

2008 Dec 03 10:23 AM

[novice_inve...:]

Are there any criteria for choosing between PST and TBT? TBT seems to be down a larger % than PST. Thanks.

2008 Dec 04 12:32 AM

[Christopher...:]

PST targets bonds of a shorter maturity; but you bring up a good point in that TBT, which targets the 30yr, is down more.

Either way, the "flight to safety" is getting more risky. Once people decide that there is a better margin of safety in equities over bonds, just sit back and watch the yields drop.

On Dec 04 12:32 AM novice_investor wrote:

> Are there any criteria for choosing between PST and TBT? TBT seems
> to be down a larger % than PST. Thanks.

2008 Dec 04 03:52 PM