Long Term Treasury Yields Likely to Rise, Pressuring Dollar Lower

The Federal Reserve is trying to hold down long term interest rates. The reason? To stimulate economic activity and encourage credit flow and especially mortgage lending. But, we have a problem. The Financial Times puts out headlines stating that “Rising bond yields present fresh challenge for the Fed.”

Long term bond rates have been rising lately. Wednesday, the 10-year Treasury hit 3.096%, a territory not breached since November 24, 2008. Thursday, this yield was at 3.134%. The same was true for 20-year Treasuries topping 4.00% the last two days.

The Fed has been engaged in an effort to purchase longer term United States Treasury issues on a continuous basis as well as Federal Agency issues and mortgage-backed securities. It has made purchases in sizable amounts weekly. Now, the Fed seems to be losing its grip on yields in the long term end of the market.

The rationale given for this slippage? The record amounts of debt the United States government has to sell.

It is true that there are and will continue to be record amounts of debt issued by the United States government coming to the market now and for as far as we can see in the future. The supply issue may have some effect in the short run, but let me provide another possibility for the rise in rates on the longer term end of the yield curve.

The argument about whether or not the central bank can significantly impact yields on the longer-term end of the yield curve has been going on for almost the entire length of my professional career. First, people think that the central bank can, and should, conduct open market operations so as to lower long term interest rates in order to spur on the economy. Then, research is produced that indicates that the Fed cannot achieve a significant reduction in long term yields through open market operations. Following this, others came to believe that it would be a good idea for the central bank to conduct open market operations to reduce long term interest rates. This was followed by another round of research indicating that the central bank cannot achieve this goal. Now, we are back at the point where policy makers believe that the Fed should attempt to keep long term interest rates low.

My reading of history is that the Federal Reserve cannot control, for any length of time, yields on long term Treasury issues. My reading of history also causes me to believe that the supply of Treasury securities cannot impact, for any length of time, the yields on long-term Treasury issues.

I am one that believes that long-term Treasury yields are determined by the appropriate expected real rate of interest and the expected rate of inflation. Since the expected real rate of interest does not change over short periods of time, the general movement in longer-terms interest rates will be determined by changes in expected inflation. And, expected inflation is dependent upon what the financial markets believe the Federal Reserve will be doing with respect to the monetization of the federal debt.

This, of course, has been a big fear in the financial markets. With all of the projected government debt coming down the road, many market participants believe that the Federal Reserve will have no choice but to monetize large portions of this debt. As more and more of the debt is monetized the probability that inflation will rise increases. And, this expectation gets built into long term interest rates.

If this is true, then the central bank faces a real dilemma. When the Federal Reserve attempts to keep long term interest rates low, it can cause a rise in inflationary expectations and this will create upward pressure on long term interest rates. If the Fed monetizes more of the debt to keep interest rates at the lower level, inflationary expectations will become even greater, putting even more upward pressure on long term interest rates. And, as long as the central bank continues to keep these long term yields below where the market wants them, the more damaging will be the consequences in the future.

In all my experience, I have not seen the Federal Reserve succeed in keeping long term interest rates below where the market wants them to be. I don’t expect them to succeed in their present efforts.

And, what about inflationary expectations? I believe that we can provide evidence from other markets that confirm this recent sensitivity to the increasing pressure on the monetary authorities to monetize the government debt. I am not concerned with the absolute levels of expected inflation, just the direction in which the spread has moved.

The spread between the 10-year government bond yield and the rate on 10-year inflation indexed government bonds is often used as an indicator of movements in inflationary expectations. The spread remained relatively constant from January 2009 through March. However, in April the spread has increased by 2 ½ times the January figure. This spread now is at a level we have not seen since early October 2008, right after the fall crisis hit. Market participants seem to be increasingly worried about what the Fed is going to have to do.

Furthermore, every time we see this spread increasing we tend to see a decline in the value of the United States dollar against the Euro and against other major currencies. Relative currency valuations are highly dependent upon changes in what central banks are expected to do because their actions can affect relative rates of inflation. If investors believe that the central bank in your country is going to monetize its government’s debt more rapidly than that of another country, the value of your currency will decline relative to that of the other country.

In this respect, the value of the United States dollar has declined over the past two days and tends to drop every time there is a rise in yields on longer term Treasury bonds. This would indicate that some of the same things affecting the yields on long term bonds are also affecting the value of the currency.

A final piece of evidence in support of this idea is that the market also responded to the minutes released Wednesday by the Federal Reserve’s Open Market Committee. In those minutes the Fed stated that “the economic outlook has improved modestly since the March meeting…” It also noted that household spending “has shown signs of stabilizing while businesses have cut inventories, investments and staffing,” implying that if consumer spending does stabilize or even increase, businesses will have to restock their shelves in order to support this spending which would be positive for economic recovery. Both of these statements foresee a stronger economy in the future, reinforcing the earlier fears of the market.

Long term Treasury yields were low because there was a flight to quality and because inflationary expectations were low. Unless there is another major shock to the system, I believe that the flight to quality is over and is in the process of being reversed. In addition, I believe that the Fed will continue to monetize the debt in increasing amounts, as the Fed also emphasized in this week's minutes that they will “stay the course” in the fight against an economic collapse. For both of these reasons, I feel that pressure will continue for long term Treasury yields to rise and for the value of the dollar to fall.

Comments

[Will Trades:]

oops, The reason i wrote the above comment, was based on the error of Mr. Mason's experience: He never saw Government able to control long term interest rates by debt monetization. Well, one thing he forgets to address is that this environment is unlike others in that it is deflationary. We are in a great depression deflationary pressure exists. Therefore, expectations of inflation cause temporary rises but the reality is that as assets are sold off the prices of goods pressures downward as well. As long as the system is afloat, it is going to be a war between the expectations and the deflation environment until a new market comes. Then, the government can deleaverage so to speak, it's ongoing debt monetization, into the growth of the economy, somehow. Maybe by . . . you fill in the blanks. i can't think anymore for now.

May 02 04:48 AM

[Bill S. Friend:]

These actions are intentionally conceived to grow the US out of debt. Huge indebtedness is sitting llike a rat in a snake unable to digest it. We need a bigger snake.
Prepare for inflation. The time to borrow massively is at a time like this when rates are so low and the fed is doing its best to contain rates, all the while knowing the eventual effect will be a weaker dollar to repay. The contortions of this are painful.
I would argue that the fed certainly can affect treasury rates, at the very least benefit of knowing that no auctions are destined for failure, as has happened elsewhere.
The resiliency of the USD is amazing, and that fact is not destined to change anytime soon.
The Chinese have been stockpiling commodities with their surpluses hedging their bets on the USD.
But I could be wrong...

May 02 07:09 AM

[Liebold:]

I agree Friend(s). You can't be your own best customer without inflation (i.e. the Fed). Dear snake/dragon: regurgitate the rat, sprinkle it with green bamboo shoots, or choke on your own tail.

May 02 10:50 AM

[ron_paulite:]

"Unless there is another major shock to the system, I believe that the flight to quality is over and is in the process of being reversed."

So maybe TPTB will introduce another shock to the system to keep long term rates low, save the dollar, make treasuries a 'quality' asset again so as to finance all our spending ...

May 02 11:27 AM

[mac123449:]

WASHINGTON -- China, wary of the troubled U.S. economy, has already "canceled America's credit card" by cutting down purchases of debt, a U.S. congressman said Thursday.

China has the world's largest foreign reserves, believed to be mostly in dollars, along with around US$800 billion in U.S. Treasury bonds, more than any other country.

But Treasury Department data shows that investors in China have sharply curtailed their purchases of bonds in January and February.

Representative Mark Kirk, a member of the House Appropriations Committee and co-chair of a group of lawmakers promoting relations with Beijing, said China had "very legitimate" concerns about its investments.

"It would appear, quietly and with deference and politeness, that China has canceled America's credit card," Kirk told the Committee of 100, a Chinese American group.

"I'm not sure too many people on Capitol Hill realize that this is now happening," he said.

www.chinapost.com.tw/b...

May 02 11:37 AM

[Harry Tuttle:]

bricki,

I agree, but the article seems to imply that higher rates drive flows out of the dollar which is not true.

I also think long term rates should eventually go up, but, other things being equal, higher rates attract dollar flows.

The only treasuries I hold are of short duration because I do not think the money market rate differential compensates the risk.

Thanks for the response.


On May 01 10:42 PM bricki wrote:

> Higher REAL rates attract inflows into the dollar. If inflation is
> 10% and the rate is 10% you have a real rate of 0. If inflation is
> 20% and the interest rate is 10% you are going to be investing elsewhere.
>
>
> And as far as buying and holding TBT... give it a try. You will quickly
> lose your shirt. TBT is a day trading instrument that gets settled
> at the end of every day. You will get eaten alive by the effects
> of this.
>
> On May 01 02:02 PM Harry Tuttle wrote:

May 02 11:48 AM

[shootpar2001:]

Yes!
Supply and demand rule the day..... that is why money is moving from Treasuries; up the risk scale.....corps. preferreds, etc.
Look at your history, bonds may outperform equities for a year or two. (not counting burst off the bottom)

Disclosures: (ACG), (PTY), (PSY)



On May 01 03:33 PM @TexasER wrote:

> Great article, very thought provoking.
>
> Thomas, I had the same initial reaction as you did. And you (we)
> might be right. Certainly there is a point where supply overwhelms
> demand and the curve moves.
>
> But I think the author's assertion is that this hasn't happened to
> the US bond in modern economic history.
>
> Yet.

May 02 01:42 PM

[Timmothy Posey:]

Let's get for real here. The inflation that is coming will be double-digits, and yes, it is INTENDED. Inflation will be rampant, and it will be the saving grace for the Obama Administration, because they will be able to report higher personal income increases than ever before. The $30k a school teacher now makes will be $70k in the next few years.

They believe that inflation will solve our problems. E.g., it will lead to higher housing prices and spur demand back into housing, and it will inflate personal incomes and salaries all to the point where we can all afford our debt. This new "government" bubble will buy time for consumers and our government to dig out from their debt and then the next deflation/crash will (supposedly) relatively mild because more consumers will have a healthier balance sheet in which to re-inflate themselves. At least, that is the current administration's thinking.

May 02 02:56 PM

[dcb:]

I agree. The fed allowing higher yields on the long end of the curve is good for dollar. keeping them supressed by buying t-bills is bad for dollar. I was reading somewhere that China aint buying anymore and our fed is doing much of the current buying.


On May 01 02:02 PM Harry Tuttle wrote:

> How do higher rates discourage flows into the dollar?
>
> It seems to be that the higher rates go the more the marginal foreign
> investor considers it is worth risking a further devaluation.
>
> Record amounts of debt may, ceteris paribus, imply lower prices and
> higher rates, but a higher rate stimulates more buyers.
>

May 02 05:59 PM

[Dave Wrixon:]

The question we all need to ask ourselves is:

"If it is so easy to borrow and inflate our way to prosperity, why has it not been tried before, and why is it not standard practice?"

Do we really have a new superior class of economic geniuses running the US at the moment, or are they falling into an economic trap that has humbled many an empire in the past?

If the dollar does tumble which now looks almost certain, US dominance of the World economy is over.

May 03 02:42 AM

[Homer II:]

".. The $30k a school teacher now makes will be $70k in the next few years."

Thats nice for the teachers. What about retirees, living predominately upon Social Security and possibly some non-cola'd pension? By my reckoning, they are being setup to be crushed. Thats not very nice.

May 03 04:09 AM

[American in...:]

It is standard practice. It was government deficit spending that pulled the US out of the Great Depression.

It was government deficit spending that pulled the US out of the 1983 recession.

There are few things worse in life than ideological blinders that prevent one from examing the world with an open, critical mind.


On May 03 02:42 AM Dave Wrixon wrote:

> The question we all need to ask ourselves is:
>
> "If it is so easy to borrow and inflate our way to prosperity, why
> has it not been tried before, and why is it not standard practice?"
>
>
> Do we really have a new superior class of economic geniuses running
> the US at the moment, or are they falling into an economic trap that
> has humbled many an empire in the past?
>
> If the dollar does tumble which now looks almost certain, US dominance
> of the World economy is over.

May 03 08:10 AM

[cannedpawn8:]

Tpoise,

Although not an present Administration fan, thats a strange scenario for them to want...

May 03 08:55 AM

[fxmaven:]

(Reply from another American expat)

Yes sometimes deficit spending is required. So you are partially right.

Yet mindless creation of money supply to create inflation, and a failure to shut down economically unproductive investment are the new variables in the US economy.

The Great Depression was not caused by the massive personal & corporate debt we have today. Hence the key to reversal was to revive investment and employment.

Previous deficit spending was luckily spent on economically productive activities (Highway construction, Wartime machinery production, and massive worker re-training (GI Bill)). Current deficit spending is just fueling consumption and bond repayments, not investment.

Big difference, it's just a wealth transfer from taxpayers to bondholders. Shareholders are a little better off than in March.

Inflating away debt has never worked - and this is a completely different question from deficit spending. USA (that ex-country of mine) needs more investment and jobs, a stable currency, and people should repay their debt in real terms.

But this will not happen as it will not get the current administration re-elected, and the real long term cure is too painful in the short term for the now enfeebled masses of the USA.


On May 03 08:10 AM American in Paris wrote:

> It is standard practice. It was government deficit spending that
> pulled the US out of the Great Depression.
>
> It was government deficit spending that pulled the US out of the
> 1983 recession.
>
> There are few things worse in life than ideological blinders that
> prevent one from examing the world with an open, critical mind.
>

May 03 01:17 PM

[History Buf...:]

Bill S. Friend,

I think you are right. Can you tell me who will loan me lots of money right now? It doesn't seem to be any of our banks!

BTW, it seems like a lot of banks are doubling the interest rates they are charging on credit cards. No one in their right mind would get into an ARM in this kind of environment.


On May 02 07:09 AM Bill S. Friend wrote:

> These actions are intentionally conceived to grow the US out of debt.
> Huge indebtedness is sitting llike a rat in a snake unable to digest
> it. We need a bigger snake.
> Prepare for inflation. The time to borrow massively is at a time
> like this when rates are so low and the fed is doing its best to
> contain rates, all the while knowing the eventual effect will be
> a weaker dollar to repay. The contortions of this are painful.<br/>I
> would argue that the fed certainly can affect treasury rates, at
> the very least benefit of knowing that no auctions are destined for
> failure, as has happened elsewhere.
> The resiliency of the USD is amazing, and that fact is not destined
> to change anytime soon.
> The Chinese have been stockpiling commodities with their surpluses
> hedging their bets on the USD.
> But I could be wrong...

May 04 10:20 AM

[History Buf...:]

American in Paris,

Although a lot of people THINK it was deficit spending that pulled the US out of the Depression, in all likelihood it was actually World War II (which did create even more deficit spending, but for a specific purpose, i.e., winning the war).

Once the war was over American industry had a field day rebuilding the rest of the world and had virtual monopolies in numerous areas because our competition had been physically destroyed by the war.

We aren't going to be so lucky coming out of this Depression ...


On May 03 08:10 AM American in Paris wrote:

> It is standard practice. It was government deficit spending that
> pulled the US out of the Great Depression.
>
> It was government deficit spending that pulled the US out of the
> 1983 recession.
>
> There are few things worse in life than ideological blinders that
> prevent one from examing the world with an open, critical mind.
>

May 04 10:23 AM

[Michael B. ...:]

Everyone likes to be clever and say US treasury yields are going to the sky (and thus the US government is headed towards bankruptcy). Thus the massive interest in this piece.

Any article saying to buy treasury bonds right now is uninteresting, unjustified, and generally doesn't have much popular appeal.

Interesting.

May 04 11:45 AM

[tunaman4u2:]

Quick question for a bond newbie...
If the government printing presses are in full effect, why do they even have to sell bonds...

"Now, the Fed seems to be losing its grip on yields in the long term end of the market. The rationale given for this slippage? The record amounts of debt the United States government has to sell. It is true that there are and will continue to be record amounts of debt issued by the United States government coming to the market now and for as far as we can see in the future"

Any answers?

May 04 03:53 PM

[altaman:]

Or, conversely the dollar cratering and driving interest rates higher. Look at the path the dollar was on, vs. foreign currencies and gold, before the Lehman failure drove people into Treasuries. As they panic about other things the dollar will resume its slide but at a steeper rate.

May 04 03:55 PM

[bullzvsbearz:]

If you want to short long gov't bonds with less volatility than say the TBT (w/ the associated leveraged ETF issues) then take a look at Rydex Inv. Long gov't Bond Fund.


On May 01 09:42 PM marketman54 wrote:

> Buy and hold TBT and watch the pinball score roll.

May 05 12:26 AM