Playing chicken with the Fed
Yields on long-term U.S. Treasury debt continued to surge higher yesterday as the market braced for a future upturn in inflation and a tidal wave of long-dated issues that will be needed to fund the bank rescues and the emerging stimulus package.
Yields on three-year notes are up by around 47 basis points from their mid-December low. But yields on ten-year paper have soared 82 points and rates on the 30-year long bond have surged 114 points. Long-bond rates have retraced more than half their decline since the autumn (https://customers.reuters.com/d/graphics/USTREAS.pdf).
Back-end yields would probably have risen even further were it not for persistent hints the Federal Reserve is thinking about buying longer-dated issues to cap them. But the market has started to call the Fed’s bluff.
MANIPULATING THE FRONT END
In the press statement accompanying its most recent interest rate decision, the Federal Open Market Committee (FOMC) gave a clear commitment it will keep short-term rates at “exceptionally low levels for some time.” In practice, the Fed will probably hold rates close to zero for the next two to three years until a cyclical recovery is well underway. But thereafter rates will need to rise to more normal levels to contain inflationary pressures.
The steepening yield curve reflects an assumption the Fed’s zero-interest rate policy will dominate the whole yield on debt maturing in 2009-2011, but have a diminishing effect on securities which mature further in the future.
LENGTHENING THE DEBT PROFILE
Federal debt held by the public has surged almost 25 percent in the last nine months, from $4.64 trillion at the end of March 2008 to $5.78 trillion at the end of December. Net debt is scheduled to increase another $1.0-1.5 trillion over the next twelve months as a result of the cyclical downturn and the huge $700-900 billion stimulus package being considered by Congress.
So far, almost all the increase in debt has been funded by issuing short-term instruments. The proportion of debt maturing within one year has climbed from 38 percent at the end of March to 43 percent at the end of December, and will climb over 50 percent within the next twelve months unless the government’s issuing policy changes.
By increasing the volume of debt that needs to be refunded regularly, the shortening profile is creating a dangerous new form of fragility within the system.
In effect, the federal government is now taking on the maturity-transformation role previously provided by commercial banks, corporations issuing commercial paper, and special investment vehicles (SIVs). Like them, it is borrowing short-term from the money markets to make long-term investments secured against tax revenues receivable over decades.
But like the private borrowers, the government will also face a liquidity crisis if at any point the market balks at rolling over the maturing short-term notes.
For the moment, a liquidity crisis is unlikely. The short-term ultra-safe instruments the Treasury is issuing are a good fit for the type of securities which investors want to hold.
But once conditions begin to normalize, investors are likely to want to withdraw some funds from the short-term Treasury market to deploy them more profitably in other assets. And overseas investors will eventually want to reduce their exposure to dollar-denominated assets.
At that point, short rates will have to jump to persuade investors to keep sufficient funds in the market to roll over all the maturity bills and notes.
This risks creating a highly unstable dynamic. Even the slightest sign of stabilization and recovery will trigger a sharp run up in short and medium term government bond yields, cascading across the rest of the bond market into higher borrowing costs on commercial paper and commercial loans.
With so much short-term debt needing constant refunding, the Fed would struggle to control the pace of future monetary tightening. Both the Fed and the Treasury therefore have a strong interest in lengthening the government debt profile.
A much higher proportion of forthcoming debt issues will be placed in the middle and at the back end of the yield curve, which is why debt prices at these maturities have been falling, and their yields rising fastest.
MANIPULATING THE BACK END
The Fed’s open market operations are normally restricted to short-term U.S. Treasury bills. But the central bank has already expanded them to include purchases of commercial paper and mortgage-backed securities issued by Fannie Mae and Freddie Mac. It will soon start funding third parties to buy securities issued by credit card companies, student lenders and motor manufacturers.
The FOMC has stated it is also “prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.”
In effect, the Fed has said it is prepared to enter the market as a “buyer of last resort” for longer-dated Treasury securities if their prices fall too much and yields rise too high. Fed officials have talked about buying longer-dated Treasuries for several months. But so far the Fed has hesitated to pull the trigger, because buying long-dated bonds is fraught with danger.
The principal purpose of open market operations is to provide liquidity by making an active two-way market when other banks and institutions fail to do so in sufficient volume. To the extent the volume of open market operations increases, and the total quantity of securities owned by the Fed rises over time, the central bank is also printing money.
When the Fed first started to expand its open market purchases in early autumn, the cost was covered by additional deposits of Treasury money into the central bank. The Treasury issued short term cash management bills, deposited the proceeds with the Fed, and the Fed used them to buy private-sector debts. In effect, the Fed and the Treasury substituted private borrowing from the money markets for public borrowing, so the impact on the total money and credit supply was neutral.
The Fed and Treasury have since run down the supplementary financing program and allowed the cash management bills to mature without replacing them. The increase in the Fed’s balance sheet has started to expand the money supply. But the increase is mostly showing up in a rise in the volume of excess bank reserves, rather than lending, so the impact on business activity and inflation is muted.
There is more inflationary risk in future once conditions normalize and demand for cash liquidity falls. But at that point the Treasury could issue more government debt, or the Fed could sell some of the government and other securities in its portfolio, absorbing excess cash from the banks. In principle, the Fed is still swapping private debt (now) for government debt (later).
But once the Fed begins to purchase long-dated Treasuries it will be unambiguously creating money. It would be turning on the printing press and monetizing the federal government’s deficit.
Since all the Fed’s operations are ultimately backstopped by the U.S. Treasury, the Fed would be using the government’s own money to buy the government’s own debt. The Fed would find itself bracketed with Germany’s interwar Reichsbank and the central bank of Zimbabwe. This is most definitely not a comparison the Fed wants drawn.
The market would almost certainly respond by labeling a long-term Treasury purchase program “deficit financing” and brace for even higher inflation. The market-clearing yield on long-dated Treasuries would rise further. If the Fed wanted to continue holding yields down below this level, it would be forced to buy a substantial proportion — in the limiting case all — of the new issues.
As in the currency market, limited intervention risks backfiring, while large-scale intervention would stoke fears about inflation. So this is a policy the Fed must hope to hold in reserve, and never have to use.