Sorry Ben, You Don't Control Long Term Rates
It is disappointing to discover that the Harvard- and M.I.T.-educated Ben Bernanke did not learn while attending school that long-term interest rates must be set by the free market. Belatedly, the Chairman of the Federal Reserve is about to learn this valuable and costly lesson because these rates cannot be manipulated lower by any central bank for a great length of time.
On March 18th, the Federal Reserve committed to buying up to $300 billion in long-term Treasuries over the ensuing six months. After that announcement, the market initially celebrated and interest rates immediately fell on the 10-year note from 3.02% to 2.51%. But less than two months later, rates have spiked up to 3.17%, 66 bps higher than the reaction low on the day of the announcement.
That jump in rates places into jeopardy the nascent recovery in the market and economy because so much of Washington's planned "healing" is predicated on halting the fall in real estate prices, which have implications for consumers' and banks' balance sheets. Thirty-year fixed mortgages, which had fallen to a recent low of 4.625%, now face the pressure of a rising 10 year note, which has a direct impact on newly-minted mortgages (as opposed to LIBOR rates which affect ARMs).
The recent rise in Treasuries has created an incredibly important standoff between Mr. Bernanke and the bond vigilantes whose clients demand a real return on their investments.
You see, rates on the long end of the curve are primarily concerned with inflation; if inflation is expected to increase, rates must eventually reflect this by moving higher. I realize that today many are mistaking the deleveraging processes seen in stocks and real estate prices as deflation but as long as the Fed continues to monetize Treasury debt, the money supply will continue to increase dramatically and deflation in the long run will be off the table.
So just how realistic is the current level of Treasuries? As noted in my commentary written in October 2008 entitled "The Debt vs. Interest Rate Conundrum", the 46 year average constant yield for the 10 year note was 7.04%. The yield rose above 3% in June of 1958 and did not drop below that rate until November of 2008! Back in 1958 the monetary base was just $38 billion and the gross Federal debt was only $279 billion (60% of GDP). Today, base money has grown to $1.7 trillion -- with more than half of that amount having been added just since last Autumn -- and the National debt has skyrocketed to $11.2 trillion (80% of GDP). Therefore, from both an economic and historic perspective the yield on the Ten year note is unnaturally and unsustainably low.
Some may also say that today's low rates are justified given the fact that Consumer Price Index increased just .1% for all of 2008. But when you look at the first three months of 2009, the CPI is already rising at a 2.2% annual rate; clearly, traders in the bond market are beginning to realize that deflation will not be our next major concern.
This, when you think about it, is completely justified given the tremendous increase in debt and money supply, which are the progenitors to rising inflation.
So how high will the Fed allow long-term rates to rise and how much money will they print in an attempt to stem that increase? Ben Bernanke may be surprised to learn that the more Treasuries he buys, the lower their prices will go. After all, printing money is the definition of inflation and investors simply cannot tolerate a negative return on their money for very long.
Will the Federal Reserve abandon its dangerous current course and let our economy experience a painful, but much needed recession or will it persist in its belief that long-term rates are under its dominion? Unfortunately, it seems clear that instead of capitulating to the bond market's clear signals and reversing course, Bernanke will continue down this path. Indeed, if long-term rates go much higher from here -- and it is pathetic to think our economy can't stand a 10-year Treasury rate of much over 3%-- don't be surprised if the Fed soon announces additional commitments to purchase even more government debt in a futile attempt to keep Treasury yields artificially low and to sustain the "recovery" now supposedly in progress. And that, unfortunately, spells disaster for both an inflationary outcome and the viability of our debt-laden and credit-dependent economy in the not-too-distant future.
The market will not be fooled by this game indefinitely, as the 10-year yield is already hinting.
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