Too Early for the Fed to Stop Purchasing U.S. Treasuries?

In the United States, since the beginning of quantitative easing policy, the Federal Reserve has bought $260bn worth of the Treasuries in order to improve credit conditions. However with the Fed’s buying program almost over, questions arise about the sustainability of the ongoing recovery in financial markets.

So far, the Fed purchasing of US Treasuries seems not to have any positive impact on the yield curve. For example, since March the average yield on US government obligations actually went up, with the 30 year bond yield going from 3.64 in March to 4.51 in August. Moreover, the buying of treasuries is only one part of the quantitative easing program. In fact, the Fed has still around $600bn worth of Agencies and Mortgage Backed Securities paper to purchase.

Also, although the supply of Treasuries is much bigger than last year due to an extensive government spending program, sales are going quite well. For instance, so far this year over $79bn of 30 year bonds were sold in 6 auctions. In comparison, last year only 4 auctions worth $48bn took place. Moreover, foreign holdings of US long term obligations have increased in spite of the global downturn. In June, they were 31% higher from the same period last year and treasuries demand was strong especially from countries with significant trade surpluses (China and Japan). In addition, because of limited alternatives for investments, the domestic private sector buying of Treasury has grown since the beginning of the crisis, with financial institutions increasing their holdings by $400bn and households by $300bn. So, at Trading Economics, we think the end of the Fed buying program of US Treasuries will not have a significant impact over the credit availability and performance of US financial markets.

Disclosure: No positions

Comments

[steve graves:]

How can you claim that the Fed's purchase of Treasuries "seems not to have any positive impact on the yield curve"? Just because bond yields have risen doesn't imply that their efforts have had no effect; who's to say that yields wouldn't be considerably higher if the Fed hadn't increased demand by purchasing $260 billion worth over the last several months? On the contrary, isn't it logical to suspect that these purchases have indeed propped up prices up and held yields lower than they otherwise would have been? Isn't that simply how the law of supply and demand works?

Aug 23 09:24 PM

[Mark Bern:]

One basic principle for creating bubbles is the greater fool principle. I am not predicting with any certainty that we are experiencing a bubble in Treasury instruments. However, as in the housing bubble, investors continue to invest in whatever is rising, wherever they think they can make a quick buck. And they always depend on the existence of that greater fool who will pay more than they do.

Treasury bonds are a lot different than housing. Speculators can play the "range" over the short term whenever bonds fall enough in price; just buy on dips and sell to the greater fool on the rally. The greater fool in this instance must be those that are looking for safety (and there would be plenty who fit into that category). I wonder, though, if long-term bonds at 4.5% will seem safe if inflation rises above 5%? I wonder if bonds will seem so safe if the Fed finds it necessary to raise interest rates to combat inflation? I wonder will bonds seem so safe for foreign investors if the dollar declines in value by another 10-20%?

Yes, one can hold the bonds to maturity and ensure a 4.5% return. But you could be repaid in dollars worth far less. I don't consider Treasuries to be that safe in the current environment. But, obviously, a lot of other people do. And this is still a free country where we are all allowed to express an opinion. Bond buyers are expressing theirs, but as the author points out, the yield is drifting higher. My guess is that it will continue in a gradual slope unless there is some unforeseen geopolitical event which could, depending upon the event and its origin, take bonds in either direction. So much for the concept of "risk-free" investing.

Aug 23 09:25 PM

[Bruce Krasting:]

Tks for this. We shall see what happens to interest rates over the next six months. I think the absence of the Fed POMO buys will make a difference. Rates will have to rise. There is just too much paper that has to be sold.

Two scenarios I see.
A) The economy recovers. Money would go to higher risk and away from Treasuries. This is the crowding out issue. What would an investor rather have, a AAA corporate or a 3% Treasury?
B) Things go wrong and we resume a decline or have no real growth in 1Q 2010. Then we would have another large stimulus plan. This economic situation would likely keep interest rates low. But the amount of new paper to be issued by the Treasury would go up by another $1T and the deficit would widen to a level where bond buyers balk. More pressure on the bonds in that situation too.

In my opinion if an investor buys 10 year Treasury bonds today at a yield of 3.5% they will absolutely lose money. They have to pay tax of 1% on that income. The remaining 2.5% will be lost to inflation.

The Fed has announced that they will purchase 1.75T of bonds. $200b in Agency debt securities, $1.25T of Agency MBS and $300b of direct Treasury securities. Did you exclude the $200b in agency debt as part of the QE total?

Aug 24 08:19 AM