– Neal Kimberley is an FX market analyst for Reuters. The opinions expressed are his own –

Dollar bears have been disappointed by the G20.

Talk of re-balancing remained just talk; the bears can discern nothing substantial. Some risk is being taken off and dollars bought back selectively. While the dollar’s general downtrend is intact, there are risks of a temporary reversal, with some seeing the euro temporarily back to $1.4500/50.

Traders can contrast G20 with the Plaza Accord in 1985 which was driven by U.S. Treasury Secretary James Baker’s persistence. But he only had to convince four peers. G20 is and will be a different story. Dealing with the G20 must be like herding cats.

Disappointment over G20 has come at an inauspicious moment. Extensive short dollar foreign exchange positions have been underpinned by the unparalleled provision of dollar liquidity by the world’s central banks.

The market has used that dollar liquidity to fund purchases of other currencies and assets. Currency speculators raised their bets against the dollar in the latest week to the most since March, 2008, data from the Commodity Futures Trading Commission on Friday showed.

But the market is realising that the major central banks are contemplating the initial steps in their exit strategies, which would naturally reverse the dollar-funded carry trade.

The liquidity bonanza that has ignited the asset market rallies is going to be pared back. Last week’s withdrawal of some emergency facilities that are deemed to be no longer needed was the first step.

Federal Reserve Governor Kevin Warsh added fuel to the fire asserting “policy likely will need to begin normalisation before it is obvious that it is necessary, possibly with greater force than is customary”.

Seemingly Warsh is not expecting the “softly softly” approach of former Fed Chairman Alan Greenspan in his post-dot com bust tightening cycle that started in mid-2004 and lasted for two years.

Market players who are using the dollar as a carry currency will note Warsh’s comments and may trim back their short dollar positioning.

The yen’s strengthening to 88.23 yen against the dollar today should be seen in the same context, as a trimming back in carry trades by Japanese retail investors, who by and large remain wedded to the U.S. currency.

The market will ultimately want to target the year’s low of 87.15 yen and ultimately the all-time low of 79.80 yen, seeking to tempt Japan’s Ministry of Finance into a reaction.

In an atmosphere where the new Japanese government seems somewhat indifferent to yen appreciation, the market has delivered general yen strength. The headlines focused on dollar/yen but traders reveal that much of the emphasis was on the liquidation of cross yen trades such as euro/yen.

Risk trades have buoyed equity markets as well as fuelling short dollar positions on the foreign exchanges. Risk trades are predicated on the assumption that government economic stimuli will promote self-sustaining recoveries. If that assumption is faulty, then the positions will need some unwinding.

However, traders are now realising that programmes like “cash for clunkers” are merely cannibalising future purchases. Consumers will respond to incentives, but without those incentives they prefer thrift. Lengthening job queues are keeping purse strings tight.

There is therefore a growing belief that the dollar may find passing strength as positioning is adjusted, which traders would see as an opportunity. Proprietorial traders will welcome the unwind and look to take advantage of any such move. Their longer-term view of further dollar weakness is undimmed.

The U.S. national interest remains focused on re-balancing. The exclusion of Mexican trucks from U.S. roads and the imposition of tariffs on cheap Chinese tyres may be dismissed as sops to President Obama’s union backers.

Yet they betray a wider agenda to revive American industrial activity. A lower dollar, even if that hasn’t worked in the past, will be an integral part of that re-balancing act.

While the dollar may therefore draw some transient strength from position adjustment, dollar bears will see the euro around $1.4500 as opportunities to buy the single currency. Moves above $1.5000 are still envisaged.

(James Saft is a Reuters columnist. The opinions expressed are his own)

There is a long list of outfits which have done well out of the banking bailout, but the U.S. Treasury and Federal Reserve are not among them.

According to calculations made for the New York Times, the Treasury’s Troubled Asset Relief Program (TARP) has reaped profits of about $4 billion, or 15 percent annualized, as eight of the largest banks to participate have fully repaid what they owe.

Meanwhile unnamed Federal Reserve officials told the Financial Times that the central bank’s liquidity facilities have generated a “gain” of $14 billion since August of 2007.

The notion of TARP profits is only true if looked at in the narrowest sense, and even then may prove to be a return as real as those of the Florida condo flippers in the summer of 2007.

The Fed, on the other hand, incontrovertibly has earned more by buying and lending against poorer quality paper, but they did it by taking on more risk - a leaf out of the book of the industry they were helping to rescue.

Wait until the Fed starts making payday loans or gets into the reconditioned small appliance finance business, then you will see what kind of “gains” a bank with a printing press and the power to create money can really generate.

I suppose the idea is to make taxpayers and voters grateful that they had the opportunity to participate in such profitable ventures - doing well by doing good, or some similar fluff.

A number of leading banks have repaid their loans made under TARP, and the government has profited by warrants it held under the deals, but this is really only a bit of runoff from the great jet of liquidity that the government has concentrated on the industry as a whole.

“What this is more appropriately described as is a return of capital; to call this a profit is to ignore trillions of dollars in taxpayer monies that have been spent, lent, guaranteed, drawn against and otherwise consumed in what will likely be the greatest transfer of wealth in the planet’s history,” Barry Ritholz, of research firm Fusion IQ, wrote on his blog.

It is one thing to justify an enormous outlay and subsidy - and make no mistake this is what the bailouts were - on the basis that it was a needed evil, but it borders on the offensive to sell it as a successful investment.

DOING WELL FROM DOING LESS

The first to repay within any loan portfolio are by definition the strongest; it is only later that the laggards show the losses. We do not know how the TARP and other programs of support will look in three or four years time, but it is likely to be worse than they look today.

Moreover, the whole idea of rigging the game and then declaring a profit is wrong. Governments can ever and always create the conditions under which their financial sectors can turn nominal profits.

They do this in a number of ways; through lax regulation, by engineering low interest rates with a sharply sloping yield curve, by limiting competition, or by providing term financing when the markets won’t do so.

These profits though are effectively a tax on the rest of the economy, and I am betting that the taxpayer and government are not getting their fair share, which is virtually all of it.

Billions and billions of dollars are flowing elsewhere - to investors, to borrowers and to employees.

There is also the bald fact that, given that there were no effective funding markets at the time that many of the loans and investments were made, the government could have extracted far higher compensation for its support.

And what about opportunity cost? How would the government and taxpayer have fared if instead of rescuing the banks, and thereby privatizing much of the profit, it seized them and sold them off in the normal fashion? Or what about if the trillions of dollars in support were used in different ways, for different purposes, or even, heaven forfend, not spent at all?

As for the Fed and its gains, the key point is that this money, which represents the extra earned above what three-month Treasury bills would have generated, is not risk adjusted.

The Fed isn’t, and shouldn’t be, a hedge fund — leveraging up and going out the risk curve to generate profits.

It too, conceivably, can allocate credit to a particular part of the economy, say housing, and thereby make the loans it makes to that sector perform and generate “profits.” But this begs two questions; is it right for them to allocate credit in this way and are the profits real or symptoms of a bubble?

This will work for a while, but as we have seen, not forever.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

– James Saft is a Reuters columnist. The opinions expressed are his own –

Come good news or bad, the U.S. treasury market is taking a sell now and wait for inflation later strategy.

Since May 21, Treasuries have been battered, sending the yield on 10-year bonds up by nearly 40 basis points to 3.53 percent, an enormous move in bond market terms.

This is where the real action is, not in speculation about whether credit ratings agencies will cut the U.S. AAA rating in a year or two; by the time they get around to saying what everyone already knows is true, the damage will have been done.

The U.S. is in the process of reflating, really re-leveraging its economy, but this time using the public purse and printing machine to replace private demand.

This may be necessary, it may even work, but what it is without doubt is risky. The Federal Reserve’s massive direct intervention in credit markets will have to be unwound if and when it works, with unforeseeable consequences, and the government’s funding needs are in the meantime intimidating.

Investors in Treasuries rightly fear the risks of inflation and of being left, eventually, holders of what the Fed is selling rather than what it is, at least for now, buying.

Stephen Lewis, of Monument Securities in London believes the surge in prices of things the Fed was buying was by definition short-lived:

“Investors quickly realised that, unless the Fed intended to be a permanent holder of the securities it had bought, or of an equivalent amount of similar securities, the favourable shift in the supply/demand balance would be only temporary,” he wrote in a note to clients.

“Sooner or later, it would give way to an unfavourable shift as the Fed unwound its holdings. More than that, even the cessation, or diminution, of the flow of Fed asset purchases might leave the prices of those assets high and dry…The prospect then would be of a sickening plunge in market prices.”

The irony on Tuesday was that bonds were hit hard even despite a successful auction of $40 billion of 2-year notes, with performance getting worse the further in the future the bonds are due for repayment. But a further series of tests are upcoming, with another $60 billion being sold this week and more to follow as far as they eye can see.

An optimistic gloss on the bond sell off on Tuesday is that better than forecast consumer confidence data had touched off a rally in stocks. Happy days, fill your boots with equities and sell those bonds. A steepening yield curve is supposed to be a sign of a recovery, right?

TREASURIES WEAKEN, OTHER VARIABLES CHANGE

That analysis is tough to reconcile with recent events. Last week, bad news and a fall in the stock market coincided with bonds tumbling. Britain was put on warning by Standard & Poor’s that it could lose its AAA rating, supposedly sparking a read-across of the same implication for the U.S., the jobs numbers looked a bit ropey and, hey presto, bonds and stocks, well really U.S. assets, fell in concert.

Moody’s on Wednesday said the U.S.’s AAA rating was stable, but strangely the rally on the back of this was not forthcoming.

But to understand why bond markets aren’t pleased with the U.S. fiscal situation, you don’t need to read-across from the British model, just read the Congressional Budget Office data.

The CBO predicts nearly $10 trillion of new debt in the decade from 2010, which will leave it at more than 80 percent of GDP. These are just astounding numbers, and while we can’t be sure, the real risk is that the bond market is telling us this is unsustainable, unfinancable over the long term.

The data may well be looking up, and I do think a tepid recovery in the second half of this year is on the cards, but surely not a recovery that is worthy of inspiring a 12 percent plus move in government interest rates in 10 days or so, and not while the Fed is busily doing its best to keep rates artificially low by buying debt directly.

The central scenario is probably a volatile bond market, a jittery one which sees inflation behind every tree but in the end keeps faith with the U.S. and with its ability and resolve to manage the economy.

The tail risk is that the bond market loses faith, and in some combination with a falling dollar begins to not reflect events but dictate them.

It is a small risk, but the bond market could be the story of the summer.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –

– John Kemp is a Reuters columnist. The views expressed are his own –

The bond market’s adverse reaction after the Fed announced no new asset purchase facilities or bond buyback programs highlights the fundamental difference between interest rates and quantitative easing (QE).

Rate cuts provide ongoing support for an indefinite period until the Federal Open Market Committee chooses to reverse them. In contrast, QE programs provide a one-off, time-limited boost that has to be continually reapplied to have the same effect.

With interest rates a decision to leave rates alone represents “no change” in policy; with QE, a decision to leave the scale and duration of the buyback program unchanged is a “tightening”.

QE is time-limited because it drives up bond prices and cuts yields only as long as buybacks continue, or are expected to do so. Once planned buybacks have been completed, or are not expected to be extended, the market will revert to its natural clearing equilibrium. Repeated doses of QE are needed just to keep yields unchanged.

This creates something of a dilemma for policymakers in both the United States and the United Kingdom. The Bank of England’s program to buy 75 billion pounds worth of government and corporate bonds will be completed in mid-June. The Fed’s program to buy $300 billion of medium and long-term U.S. Treasury securities finishes in September.

Once the current round of purchases are complete, both central banks will have to decide whether to embark on another one (intensifying criticism about inflationary financing of public debt) or end it (triggering a sharp yield increase).

In fact, yields will start rising well ahead of the formal end of the programs, unless the Bank and the Fed give a clear signal they will undertake further purchases.

The dilemma is especially pressing for the Bank of England given the imminent expiry of the current round. Officials will come under pressure to clarify their intentions at next week’s Monetary Policy Committee meeting. But the Fed too will face growing pressure over the summer to signal whether the existing programme will be extended beyond September.

It was the Fed’s failure to announce new and larger QE programs yesterday, and the implication that current support might expire in a few months, that caused the bond sell off overnight. Yields on 10-year U.S. Treasuries jumped to 3.16 percent, the highest since Nov. 2008 on Thursday, undoing all of the gains since the Fed announced its QE programme last month.

Terminating QE programs and not replacing them would amount to a sharp tightening of policy and trigger a large, destabilising rise in yields. So the central banks might opt to scale them back instead — continuing to buy debt, but in progressively smaller quantities — as a smoother way to withdraw exceptional support.

The problem is that if QE programs are not withdrawn fairly soon, they risk breaking down anyway under the weight of their own internal contradictions. Because the longer programs run, the more debt central banks will monetize, and the more fears of an eventual inflationary breakout will grow.

Eventually upward pressure on yields caused by increased fears about inflation will offset the downward pressure from QE purchases, neutering the programs’ effectiveness. At that point, ever larger quantities of QE will be needed to achieve the same degree of yield reduction or stabilization.

QE may have bought the central banks a little time but returns will diminish later in the year. The sooner they can articulate a managed retreat the more likely they are to retain some influence over the back end of the yield curve.

– Bernd Debusmann is a Reuters columnist. The opinions expressed are his own –

The U.S. case for isolating Cuba and keeping it out of international meetings such as this week’s Summit of the Americas sounds simple: the country doesn’t have democratically elected leaders, it holds political prisoners, it violates human rights and its citizens can’t travel freely. All perfectly true.

But if the logic used for isolating Cuba were applied consistently, neither China nor Saudi Arabia, for example, should have taken part in the London G20 summit. The U.S. State Department estimates China has “tens of thousands” of political prisoners and describes it as “an authoritarian state in which the Chinese Communist Party … is the paramount source of power.”

That has made little difference to the close relationship of mutual dependence between the U.S. and China, the largest creditor of the United States. During U.S. Secretary of State Hillary Clinton’s February visit to China, pragmatism triumphed over human rights concerns as she urged the Chinese to keep buying U.S. treasury bonds.

In comparison to China’s “tens of thousands,” the State Department’s latest human rights report quotes a Cuban human rights group as saying the government there held at least 205 political prisoners at the end of 2008, down from 240 at the end of 2007.

The Saudi monarchy, according to the State Department report, denies its citizens the right to change the government peacefully, holds political prisoners, curbs free speech, restricts religious freedom, tolerates violence against women, and sanctions corporal punishment. The list goes on and includes lack of due process in the judicial system.

If the logic applied to Cuba were consistent, U.S. citizens should be banned from traveling to North Korea, an “absolute dictatorship” where the State Department noted extrajudicial killings, disappearances, arbitrary detentions, and political prisoners. Instead, the only country to which the U.S. government restricts travel by its citizens is Cuba.

In advance of making his first appearance at a Hemispheric summit this week, U.S. President Barack Obama eased restrictions his predecessor, George W. Bush, had imposed to make it more difficult for Cuban-Americans with relatives on the island to travel and send money there. Obama also allowed U.S. telecommunications companies to bid for Cuban licenses.

These are small steps that fall far short of lifting the 47-year-old U.S. trade embargo on Cuba, a Cold War measure that demonstrably failed in its aim to bring down the communist government of Fidel Castro, who defied 10 successive U.S. presidents, both Democrats and Republicans, before he formally handed power to his brother Raul last February due to a long illness.

HAVANA-WASHINGTON THAW?

Raul Castro, who is 77 and was Cuba’s defense minister for almost five decades, has since made several key changes in the leadership. They included firing foreign minister Felipe Perez Roque, one of a group of young officials whose dedication to Fidel Castro was so fierce they earned the nickname “tropical Taliban.” He was replaced by Bruno Rodriguez, a less doctrinaire foreign service veteran.

Some Cuba watchers saw this change as a move to facilitate efforts to thaw relations between Havana and Washington. How far and how fast Obama will go is certain to be a topic at the summit in Trinidad and Tobago where Cuba is the only country in all the Americas not invited.

Advocates of lifting the embargo, a policy change that would finally bring the United States in line with the rest of the world, see light at the end of the long tunnel. “This is the beginning of the end of the worst, least successful foreign policy experiment in the history of the United States,” in the words of David Rothkopf, head of a consultancy who blogs at Foreign Policy magazine.

Wishful thinking? Lifting the embargo would require repealing legislation — including the controversial 1996 Helms-Burton law - that penalizes companies doing business with Cuba. In one of its more bizarre interpretations, U.S. pressure resulted in Mexico City’s Sheraton hotel expelling a 16-strong Cuban delegation attending an energy conference there a few years ago.

The beginning-of-the-end school of thought points to legislation now pending - The Freedom to Travel to Cuba Act - which would allow all Americans, not only Cuban-Americans with family on the island, to visit. If that act were passed, a study for the International Monetary Fund estimates that up to 3.5 million Americans could visit annually.

Cuba is not on the official agenda of the Trinidad summit (the fifth in a series that began in Miami in 1994) but Venezuela’s left-wing, anti-American president, Hugo Chavez, is certain to bring it up, along with a demand that the 34-member Organization of American States readmit Cuba. Its membership was suspended in 1962.

The guideline that only democratically-elected leaders can take part in summit meetings dates from the 1994 gathering - and even then, the logic was flawed. The Miami meeting’s participants included then Peruvian President Alberto Fujimori, a leader of dubious democratic credentials whose acts in office included dissolving Congress and closing the country’s courts.

He then won elections boycotted by the opposition. This month, a Peruvian court sentenced Fujimori to 25 years in jail for human rights abuses and involvement in two military massacres during a campaign against left-wing guerrillas.

Obama campaigned for president on a platform of “change we can believe in.” His moves on Cuba will provide a good indicator of how much of a change agent he really is.

– James Saft is a Reuters columnist. The opinions expressed are his own –

Efforts to reflate the economies of the U.S. and Britain are running into one potentially major problem; the bond market.

Appetite for government debt in recent sales has been very poor, raising the cost to the two governments of borrowing and blunting their efforts to bring down market interest rates by buying back their debt.

This is a big risk for British and U.S. efforts to rescue their economies, and could be yet another self reinforcing downward force if holders of government debt get the frights.

Both countries are running hugely expansionary fiscal stimulus programs that will need to be paid for by gargantuan sales of government debt. At the same time both have such low official interest rates, 0 to 25 basis points for the U.S. and

50 basis points in Britain, that they are engaging in purchases of their own debt, or quantitative easing, in the hope that this lowers rates for consumers and businesses and encourages money to be spent or invested.

It is impossible to know exactly how effective the policy is, after all we don’t know what rates would be without it. We can though see two things clearly; there are lots of sellers when the U.S. and Britain seek to buy their own bonds, but when it comes to the far larger operation of issuing bonds to fund ongoing needs, investors are markedly less enthusiastic. The U.S. Treasury got a very poor response on Tuesday when it auctioned $6 billion of 9-year, 9-month inflation-indexed notes at a yield of 1.589 percent, better terms for investors than similar issues on the secondary market at the time. Of particular note was the fact that so-called indirect bidders, mostly foreign central banks, stepped up for just 26.1 percent of the sale, as against 47.2 percent at the last such auction in January, which was before the policy of Fed purchases of Treasuries was announced.

Mohammed El-Erian of leading bond investor PIMCO told CNBC that government bonds were “not worth owning right now” because of the “tremendous” amount of debt the U.S. will have to sell.

The Fed will buy up to $300 billion worth of longer-dated Treasuries over the coming months to help keep interest rates low throughout the economy but at the same time it is buying from a market that is well aware that the Treasury needs to sell some $2 trillion of debt this year.

Speaking in Tokyo, it was clear that Dallas Fed governor Richard Fisher is aware of foreign investor’s concerns and has been seeking to reassure:

“Demand for U.S. Treasuries … will be determined by their attractiveness relative to alternatives and they may be judged more, rather than less, attractive under most reasonable future scenarios,” he said on Wednesday.

The Fed is determined to “short-circuit” any inflationary consequence of its balance sheet growth, and is in the process of acquiring new tools to help, he said.

“We realize … we are at risk of being perceived as monetizing the fiscal largess of Congress,” Fisher said.

Exactly. And while some might argue that the higher interest rates the U.S. may be paying will inflate away unpayable debts, this is perception that if anchored among investors, can very easily take on an extremely dangerous momentum of its own.

IT’S NOT EASY BEING BRITAIN

Similarly, the Bank of England intends to buy up to 75 billion pounds of assets, mostly gilts, over three months, but similarly Britain plans to issue a record 147 billion pounds of gilts in the coming financial year. There is also the possibility of more issuance to come if an upcoming budget includes new provisions for simulative spending.

Britain was unable to sell more than 100 million pounds of 40 year gilts at the end of March, the first such failure since 1995, and had to make heavy concession at an auction earlier this week.

All in all, it’s a sort of strange mirror to the criticism that is made of temporary stimulus measures; that because taxpayers can tell they will be forced to pay in future for the goodies they are given now they may save, blunting the impact of the stimulus. In the same way, today’s bond buy backs will need to be financed via tomorrow’s taxes, bond issues or eroded via inflation, making the current path of policy a very difficult tightrope.

It may be that in a world of poor alternative investments both countries can sell their debts at reasonable prices, but along with and interacting with currency moves, it is an important vulnerability.

The bond market vigilantes, who used to enforce a rough and sometimes destructive justice, may be saddling up again.

– John Kemp is a Reuters columnist. The views expressed are his own –

Intense criticism of the Fed’s role in the financial rescue program and the decision to triple its balance sheet, including monetizing a portion of the Treasury’s debt, has forced the central bank to issue an unusual defense of its actions (http://www.federalreserve.gov/newsevents/press/monetary/20090323b.htm).

It attempts to placate critics by acknowledging the real risk of inflation, and marks the Fed’s first attempt to set out an “exit strategy” for ending quantitative easing and other credit programs once the crisis is safely passed.

The joint statement issued with the U.S. Treasury reflects “the common views of the Treasury and the Federal Reserve on the appropriate roles of the Federal Reserve and the Treasury during the current financial crisis and in future.”

The last time the Fed and Treasury were forced to reach such an agreed statement defining their respective responsibilities was in 1951. Over the previous 15 years, monetary and fiscal policies had largely become fused as a result of the Great Depression (with interest rates kept artificially low to support recovery, then abandoned as a tool of monetary management in favor of reserve requirements) and World War Two (with rates repressed to help finance the government’s massive borrowing program).

Even after the war had finished, the Fed held short-term interest rates at just 1 percent. Rates did not begin to rise until the start of 1948, and they were still at just 2 percent by the end of 1952 (https://customers.reuters.com/d/graphics/WARTIMEFINANCE.pdf).

Crucially, the Fed also enforced a 2.5 percent ceiling on long-term Treasury yields through open market operations to hold rates down and support the federal government’s massive wartime borrowing program and the need to refinance the debt at low cost. Precisely what the Bernanke Fed is now doing through its Treasuries purchase program.

The distortions created in financial markets as a result of a long period of ultra-low rates and massive government borrowing made an “exit” from the program extremely difficult.

One result was the huge bout of post-war inflation in the late 1940s, when the massive amount of liquidity in the system intersected with the removal of price controls, industries geared to wartime rather than consumer production, and the outbreak of the Korean war.

Copper prices, for example, doubled between 1946 and 1948 and there were smaller but sharp increase in the price of most other raw materials (https://customers.reuters.com/d/graphics/METALSPRICES.pdf).

Not until 1951 were the Fed and Treasury able to reach an accord on their respective roles, and was the Fed able to start gradually normalizing interest rates. The Fed gradually loosened its control over long-term rates and allowed them to drift upwards.

The joint statement issued by the Federal Reserve and Treasury on Monday evening reiterates that “Actions that the Federal Reserve takes … such as loans or securities purchases that influence the size of its balance sheet, must not constrain the exercise of monetary policy.”

It notes that the Treasury has a “special financing mechanism” which helps the Fed manage its balance sheet. The Treasury used this supplementary financing program to sterilize the Fed’s asset purchases during the early stages of the crisis in September and October 2008 by issuing extra cash management bills to soak up the additional liquidity the Fed was pumping into the system and prevent a build up of (potentially inflationary) bank reserves.

The supplementary financing program was subsequently abandoned in favor of a more expansionary policy of unsterilized asset purchases. But it could be reintroduced to issue new Treasury securities and drain excess bank reserves and liquidity from the system if necessary.

STERILISATION

But the most important part of the joint statement notes “the Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves.”

What this last point means, in plain English, is that the Fed recognizes that the massive increase in bank reserves caused by its purchases of financial assets for cash or easily marketable securities does pose an inflationary risk once the heightened demand for cash is saturated, or starts to fall back to more normal levels.

The Fed wants to head off this risk by being able to sterilize some of the excess bank reserves at the appropriate time in future. In particular, it wants the ability to replace the bank reserves (which are cash-like instruments that banks can tap on demand) with longer-term liabilities (which will tie up bank funds and cannot be accessed immediately).

One option is to have the U.S. Treasury issue debt to the market (draining excess funds from the banking system) and depositing the proceeds with the Fed (where they will be under the control of the government, rather than the banks, so pose less inflationary risk).

The total volume of Fed liabilities would still be the same, but ownership would switch from the private sector (where it might be inflationary) to the government (where it would simply represent an inter-governmental transfer that would allow the Treasury to fund some of its massive borrowing requirement). This is what the Fed means about the Treasury being able to help the Fed manage its balance sheet.

NEW FED DEBT

The other option is for the Fed itself to start issuing debt securities to the banks, which they would buy with cash and excess reserves. The Fed would essentially swap one form of liabilities (excess reserves) for another (Fed debt). If the debt was structured appropriately, it could be much less “money-like” and liquid, absorbing some of the excess liquidity in the system.

What the Fed is hinting at in this statement is that it will ask Congress for the (unprecedented) power to issue its own debt securities. The advantage of these Fed securities would be threefold:

(1) Because they would be issued by the Fed rather than the Treasury, they would not count toward the federal government’s debt ceiling. Since they will in fact be contingent liabilities of the United States government, Congress might choose to impose some restrictions on the amount of debt the Fed can issue, and other oversight requirements. Fed officials are likely to oppose this, however, arguing they must preserve maximum operational “flexibility” to respond to crises and changing conditions.

(2) By design, Fed securities will be less liquid than cash, bank reserves or U.S. Treasuries. Various restrictions could be placed on how they are traded. For example, the Fed might insist that they can only be held by member banks of the Federal Reserve System. This would make them less money-like and reduce the risk that banks would be able to use their holdings as quasi-reserves against which they can safely extend new loans. Or they could simply be made non-tradable like U.S. savings bonds. The key point here is that the Fed securities have to be less liquid and money like than the bank reserves they will be replacing. They will be a very special form of debt.

(3) Banks will probably be compelled to hold some of these new securities as part of regulatory reforms that will oblige them to hold more capital. That would give the Fed a guaranteed market into which it could sell these securities. It would help drain liquidity from the system by replacing excess reserves (which the banks are holding optionally) with special Fed securities (which they would have to hold as a matter of law).

– John Kemp is a Reuters columnist. The views expressed are his own –

Investors have started to balk at absorbing large quantities of U.S. government debt, taking on substantial inflation and devaluation risk in return for little reward. While the government has no trouble placing short-term debt with a maturity of up to 2 years, longer-dated securities are proving much harder to sell.

Increasing resistance from the market explains why the Federal Reserve felt it had no choice but to announce it would start buying back longer-term U.S. Treasury securities last week, in a $300 billion program of direct quantitative easing and monetization.

The attached chart (https://customers.reuters.com/d/graphics/TREASAUCTIONS.pdf) shows the amount of 10-year U.S. Treasury debt placed at each of the auctions since the beginning of 2008, the interest rate which the government offered (coupon yield), and the range of rates (high, low, median) the market actually accepted through the auction process.

The government has been steadily cutting the coupon rate on offer from 4 percent in September 2008 to 3.75 percent in January 2009 and 2.75 percent at the auctions held in both February and March. But the market’s appetite for longer-term debt at such low interest rates has been waning.

The median yield which the market has demanded in the auctions has risen steadily from 2.35 percent in January to 2.71 percent in February and 2.98 percent in March. The high yield is up from 2.42 percent in January to 3.04 percent in March.

The March auction results show the government’s borrowing program was in increasing trouble. The median yield the market accepted (2.98 percent) was 23 basis points above the coupon the government was offering (2.75 percent); the government was forced to place the issue at a substantial discount (the debt was sold for an unusually large discount of 2.49 percent to its face value, or just 97.50 cents on the dollar).

The ratio of bids placed to securities sold (the “bid-to-cover” ratio) was also very low in both February and March (2.2 bids to every 1 sold), confirming that investors were looking for more yield than the government was readily paying.

Moreover, the proportion of securities purchased by primary bond dealers for their own account (60 percent) was down sharply in these auctions compared with last year (when 70-80 percent was normal). Instead, large shares went to indirect bidders (35-37 percent) which include foreign central banks bidding through the Federal Reserve Bank of New York, which may not have strictly commercial motives. The residual went to direct bidders via the primary dealers.

In the absence of the Fed move, the government would almost certainly have needed to raise its coupon from 2.75 percent to 3 percent or even higher at the next auction. It would have reversed the downtrend in place since last autumn and sent a powerful signal to the market that lack of demand was driving long-term interest rates higher.

The buy-back program — targeting 2-10 year Treasury securities — looks like an attempt by the Fed to forestall a rise in coupon payments that would otherwise have been inevitable, triggering a sharp rise in long-term borrowing costs across the economy.

But the program’s likely effectiveness is open to question. Yields on 10-year Treasuries have already risen more than 20 basis points from last week’s lows, and are now just 30 points below the level prior to the Fed’s announcement. Given the size of the government’s borrowing needs — which dwarfs the $300 billion buy back program — the program is unlikely to hold back the rise in yields for long.

– John Kemp is a Reuters columnist. The opinions expressed are his own –

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.