The Fed Scares Bond Markets

The Fed has at last spoken.  $600 billion in the next 8 months will be sloshed around the world’s financial system.  Commentators point out that QE2 is only just above a quarter the amount of QE1, and it is not an instant injection. The first slosh of $2 trillion was made in great haste in 2009, and was intended to stop the world’s financial system from disintegrating.  This objective was successfully achieved by the Fed showing itself willing to buy 30 Year Bonds to drive down longterm interest rates, and show its faith in the economy over the longer term.

This time the current sloshing of funds is not being made in the midst of a crisis, but money issuance is being presented as simple everyday economic management, as an attempt to prompt people to become more economically active, and boost the current disappointing level of economic recovery to accelerate.

And that’s the point.  This time the Fed isn’t buying hardly any long term bonds.  Only 5% of the money will go on bonds dated over 10 Years.  The Fed is pretty much only willing to buy IOUs from the US Government dated at less than 10 years as of now.

This fact has hardly been commented on, yet to my mind is hugely significant.  The Fed is worried that the issuing of longterm debt will not be a good bet on its own books.  Which means the Fed expects inflation and interest rates to be higher longer term after all.  They are signalling not confidence now but caution.

That in turn is not the boost for equities and commodities, that QE2 is so far being presented as, but a highly cautionary piece of information to investors and businessmen.  If the Fed no longer wants to buy long term US Government debt, it is not a boost at all but a deafening roar of  warning.

30 Year bond rates surged in the day from 3.9% top 4.1%.  If this continues, the issuing of this latest batch of QE will do more to unsettle the recovery by raising expectations of interest rate rises, and of inflation, than to help it.  The Fed has managed to deliver exactly the wrong signal to bring back confidence to markets by making this obvious choice to cut longer term exposure for itself.

No wonder countries that desperately need to borrow longer term to get out of their current economic predicaments such as Greece, Portugal and Ireland are looking sick this morning, with their 10 year bond rates shooting higher.  This is an own goal by the Fed.  The message that the funds available to slosh around and rescue countries in trouble, are finite has been delivered loud and clear.  Surely it would have been wiser to sit tight for a few more months, and not reveal their own concerns with lending to indebted governments.  QE2 is already looking like a serious error.

Yields on 10-year Irish bonds surged this morning to a post-EMU high of 7.41pc.

Greece was able to borrow from the EU at 5pc under its €110bn rescue in April. This rate is no longer available. Prof Whelan said the EU’s charge under the newly-created rescue fund (EFSF) would be more like 6pc. “It would not be a soft-touch,” he said.
The trigger for Ireland’s bond hell this week was of course the Franco-German deal preparing the way for orderly defaults and bondholder haircuts for eurozone states that get into trouble. This shift in policy changes the game entirely. Why would pension funds step into distressed debt markets after they have been told that the EU will, suddenly, no longer stand behind the debt?

What AEP (Ambrose Evans Pritchard) doesn’t mention is that the Fed running scared of US longer term debt has also played a part here.  The limits of bail-out are being reached on all fronts with the inevitable consequences to the real economy.  Why the equity and commodity markets see all this as bullish defeats me!

(As most people think the Fed is part of the US Government, it is not surprising people don’t realise the significance of the Fed avoiding longer dated IOUs)

FT – Long-term US Treasury bond yields rose sharply after the Federal Reserve announced on Wednesday it will primarily buy debt with a maturity of less than 10 years under its second round of quantitative easing.
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