Friday, May 22, 2009
The Fed is trying to fight a force of nature—the bond market—and they are bound to lose. Purchasing long-maturity Treasuries, mortgage-backed securities or corporate bonds in an atttempt to keep their yields low is a self-defeating strategy, since it at some point it will supply unwanted dollars to the world that will fuel inflation. Ultimately, inflation and inflation expectations are what drive bond yields. If the Fed buys too many bonds, rising inflation expectations will kill the world's demand to own bonds, and yields will rise. It's that simple.
So far this year, the yield on 10-year Treasuries has risen from 2.05% to 3.4%, and that is just a down payment on the eventual rise. Yields fell at the end of last year because the market came to believe that deflation and depression were highly likely to engulf the U.S. and global economies. Now we know that those dangers were vastly over-estimated. So yields couldn't remain at 2% or even 3%. If the U.S. economy is in the process of recovery, even tepid growth of 1-2% is not low enough to justify Treasury yields of 3% or lower. And if inflation manages to rise just a little above where it has been in the past several years—which shouldn't be too hard, given the Fed's massive monetary stimulus—that only adds fuel to the rising interest rate fire.
As politicians should know (though they refuse to believe), the economy is not something that can be easily manipulated according to their whims or preferences. As the Fed should know (but amazingly they seem to ignore this), long-term interest rates are set by market forces, not by the Fed's Open Market Committee, whose only job is to attempt to control very short-term interest rates.
Rising 10-year yields will put a floor under conforming mortgage rates, which have most likely already hit bottom. Yields on jumbo mortgages still have room to fall, however, as suggested by the second chart.
Full disclosure: I am short Treasury bonds, via a fixed-rated mortgage and a long position in TBT.
Posted by Scott Grannis at 8:28 AM