The Fed vs Treasuries: Stress Tests Forgot About Rates

A: One big thing the recent bank stress tests do not spend a lot of time on, is what happens if borrowing costs surge because of unintended consequences with the treasury market? It seems instead the stress tests focused on unemployment, GDP, and house prices. BUT WHAT ABOUT RATES? We are where we are with super low rates and seeing LIBOR come in dramatically - what is this doesn't last or we get another round of surging borrowing costs? With the treasury market selling off during this most recent rally, an environment is setting up where the fed will have to step in and purchase large amounts of treasury securities. This is part of the plan and is not news. So far, the fed has announced plans to 'print' about $1.25Trln as they purchase agency securities and help provide liquidity in that market. They capped treasury purchases to $300Bln, in essence saving their ammunition for later use - hmm, why would they do that? With treasury issuance set to soar to raise $3.25Trln of debt for this fiscal year, demand will have to come internally from our fed in some way, shape or form. Expect it, especially if our foreign funders decide to wind down both holdings and future purchases of our treasuries.

Umm, 30YR mortgage rates went to 4.675% because of uber aggressive action by our fed and a zero interest rate policy. LIBOR came in big time because of this kitchen sink action and policy - increasing the confidence amongst banks lending to each other. Rates are at all time lows and a refinancing wave that likely avoided a catastrophe with expected upcoming ARM resets. We are likely at the floor of interest rates right now. The challenge will be for the fed to keep rates this low, and prevent them from rising. But if they do rise, how does this change the stress on the banks and their toxic holdings if consumers/businesses either:

a) can't meet debt service obligations if rates rise, or
b) affect the housing market and housing prices if rates rise bringing down affordability?
c) banks NIM's?

As Calculated Risk just said to me:

"...a large portion of the capital required is coming from preprovision earnings over the next two years - and that requires healthy NIMs. Right now many of the banks are running net interest margins of over 400bps (nice), but that changes if rates increase."

Seems like something worth watching out for, dont ya think? In a perfect world, there would be no need for our fed to step up and buy treasuries in what amounts to modern day printing of money, to keep rates low. But this is far from a perfect world and the fed will do exactly that. The last thing the fed wants, or anybody for that matter, is for the treasury market to roll over sending borrowing costs higher for everyone. Many, including myself, feel this to be one of the unintended consequences unique to this slowdown. I just dont think the fed can successfully hold down the natural market forces associated with the treasury market.

Bloomberg's article, "Mortgages Over 5% Mean Fed Purchases as Bonds Slump", suggests that we have become a society that can't handle mortgage rates over 5%:

The world’s biggest investors are increasing bets that Federal Reserve Chairman Ben S. Bernanke will boost purchases of Treasuries as the steepest losses on government debt since 1994 send mortgage rates above 5 percent.

The slump in Treasuries the past seven weeks pushed yields on longer-maturity bonds up by more than half a percentage point and sent average rates on 30-year mortgages to the highest since the start of April, according to North Palm Beach, Florida-based Bankrate.com.

Investors anticipating an expansion of the Fed’s Treasury purchases were disappointed after the Federal Open Market Committee’s April 29 meeting, when policy makers left the size of planned buybacks unchanged and said the economy is showing signs of stability. The government is likely to sell a record $3.25 trillion of debt this fiscal year ending Sept. 30, according to Goldman Sachs Group Inc., to finance bank bailouts, economic stimulus plans and fund a growing budget deficit.

“If all of a sudden this rise in the 10-year yield feeds into higher all-in mortgage rates, that’s when we think the Fed will come in with a vengeance” to increase its Treasury purchases, said Joseph Balestrino, a money manager at Federated Investors in Pittsburgh, which oversees $21 billion in bonds. “We are a buyer.”

Recall what modern day printing, via OMO at the NY Fed, means:

The electronic credit was 'created' out of thin air by the fed, and BAM, you have more money injected directly into the economic system but first deposited into the banking reserve system! In this case the newly minted electronic money goes to the primary dealer's account that sells the assets to the fed. This is the 'printing money' that is associated with quantitative easing and is what hyper-inflationists worry about. The entire process is very dollar negative. Don't believe me though, the fed states it clearly:

How will purchases under the agency MBS program be financed?

Purchases will be financed through the creation of additional bank reserves.

I would not be surprised to see the fed announce that they will INCREASE PURCHASES OF TREASURY SECURITIES TO OVER $1Trln, at some point in one of their statements during the next 2-3 quarters. Questions we should ask ourselves is:

1) how will this affect the treasury market (borrowing costs tied to bond yields) and for how long?
2) how will this affect the US dollar?
3) how will this affect dollar inverse trades: precious metals, oil, other commodities?
4) how will agency debt be affected if purchases are shifting to treasuries?


Here is what the dollar has done so far, over the past year when deflation hit and the fed aggressively lowered rates - notice the rise in the US dollar for most of 2008 (a swelling of the US dollar is called for by Fisher's Debt-Deflation theory), as banks started to hoard dollars and asset prices fell:



Its worth watching out for this because it's not out there now, but may be there in the future and change the playing field in the world again. Either we adapt or die. Let's see what happens as we go through 2009.

Is the fed big enough to move the treasury market? If so, for how long? Will debt deflation and its dollar swelling tendencies overpower the dollar negative nature of aggressive quantitative easing policy? This really is a story that will pave the road ahead - will it be smooth or will it be rocky? I think we will have another rally in treasuries when the fed announces an increase in purchases, bringing rates down again, but I doubt it will last for long. This is when you may see the dollar inverse trades heat up. In the end, I think the fed is not powerful enough to control longer term rates for long, and so I would expect generally higher rates in the future. I think this, and higher taxes as a side effect of policy/slowdown, can potentially combine to spark the next wave of this process - prolonging the duration of this recession. The question is, how healthy are we when higher borrowing costs and taxes hit home and can consumers/businesses handle this shock?