Fed Bond Buying’s Unintended Consequences May Mean Higher Rates
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By Cordell Eddings
Oct. 4 (Bloomberg) -- A second round of bond purchases by the Federal Reserve may have the unintended consequences of pushing borrowing costs higher, say a growing number of U.S. government securities dealers, strategists and economists.
Yields on 10-year Treasury notes, a benchmark for everything from home mortgages to corporate bonds, rose last month for the first time since March even as the central bank hinted that it may conduct more so-called quantitative easing to bolster the economy. The median forecast of more than 60 estimates in a survey by Bloomberg News is for yields to keep rising the rest of this year and through 2011.
Based on what the Fed bought in 2009, yields are trading as if it has already acquired an additional $315 billion to $670 billion of securities, according to Deutsche Bank AG, one of the 18 primary dealers that trade with the central bank. Policy makers will announce plans buy $100 billion to $1 trillion in Treasuries before the year is out, a survey of 12 of the 18 dealers show. Three don’t expect the Fed to buy additional debt.
“A lot of quantitative easing is already priced into the market,” said Joseph Leary, an interest-rate strategist in New York at Citigroup Inc. The firm, also a primary dealer, estimates that purchases of $100 billion per month would push Treasury yields down about 0.50 percentage point, and that about half of that is already reflected in prices, he said.
The yield on the benchmark 2.625 percent note maturing in August 2020 ended last week at 2.51 percent, up from 2.47 percent at the end of April, according to BGCantor Market Data. The price rose 27/32, or $8.44 per $1,000 face value, last week to 101.
Yields will climb to 2.58 percent by the end of the year and to 2.97 percent by July, according to the average forecast of at least 60 contributors in Bloomberg surveys that give a higher weighting to the more recent estimates.
Based on what happened when the Fed began purchasing $1.725 trillion of government debt and mortgage securities in 2009, lower yields isn’t a foregone conclusion. Treasuries lost 3.72 percent last year as a drop in bond prices drove the yield on the 10-year note to 3.84 percent from 2.22 percent.
“Quantitative easing is priced into the picture,” said Sean Simko, who oversees $8 billion at SEI Investments Co. in Oaks, Pennsylvania. “When the market does turn, as we’ve seen in the past, it will turn sharply and very swiftly.”
Speculation the central bank will decide to purchase additional bonds as a way to pump money into the economy has heated up since Fed Chairman Ben S. Bernanke and policy makers said Aug. 10 they would reinvest proceeds from maturing mortgage holdings into government debt.
Since then, reports have shown the economic recovery may be faltering. The Labor Department will likely say on Oct. 8 that the unemployment rate rose to 9.7 percent in September from 9.6 percent in August, according to the median estimate of 58 economists surveyed by Bloomberg.
“We are not out of the woods on the economy front yet,” said Mark MacQueen, partner and portfolio manager at Austin, Texas-based Sage Advisory Services, which oversees $8.5 billion.
Treasuries were little changed on Oct. 1 even though New York Fed President William Dudley said the outlook for job growth and inflation is “unacceptable,” and that more monetary easing is probably needed to spur growth and avert deflation. The Federal Open Market Committee next meets to decide monetary policy Nov. 2-3.
“Further action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident that we will see better outcomes for both employment and inflation before too long,” Dudley, who serves as vice chairman of the FOMC, said in a speech in New York.
Dudley estimated that $500 billion of purchases would add as much stimulus as reducing the Fed’s benchmark rate 0.5 percentage point to 0.75 percentage point, depending on how long investors expect the Fed to hold the assets. The Fed has kept the target rate for overnight loans at a record-low range of zero to 0.25 percent since December 2008.
The first round of quantitative easing lowered the 10-year yield between 50 and 60 basis points since November 2008, said Joseph Gagnon, a former Fed official who is a senior fellow at the Peterson Institute for International Economics in Washington. He estimated a second round would “likely be at least $1 trillion,” and have a smaller market reaction.
‘More Muted Effect’
With financial markets functioning better now than in early 2009, “my own guess is that further uses of QE would have a more muted effect,” Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said in a Sept. 29 speech in London.
Bernanke has succeeded in narrowing the difference in yields between mortgage securities, which also influence home loan rates, and Treasuries. The gap between the 30-year current coupon Fannie Mae bond and the benchmark 10-year Treasury shrank to a 0.83 percentage point on Sept. 27. It averaged 1.23 percentage points in the five years prior to the collapse of Lehman Brothers Holdings Inc. in September 2008.
The average rate on a 30-year fixed mortgage fell to 4.37 percent on September 23, according to Freddie Mac, near the 4.32 record low since the McLean, Virginia-based mortgage finance company began keeping records in 1971.
“The Treasury market looks expensive, but rates for now have a lid on them with the Fed buying, and you still don’t want to fight the Fed,” Sage’s MacQueen said.
‘On The Accelerator’
Investors seem to be betting that low borrowing costs will lead to faster growth. The Standard & Poor’s 500 Index had its best September in seven decades, climbing 8.8 percent, as concern eased that the slowdown will lead to a prolonged period of deflation, or falling prices.
“At these yield levels the value in the fixed income market resides outside of Treasuries,” said Jeffrey Schoenfeld, partner and chief investment officer in New York at Brown Brothers Harriman & Co., which manages $33 billion in assets.
Investors have been piling into corporate debt to capture yields that average 2.81 percentage points more than Treasuries, according to Bank of America Merrill Lynch index data. That compares with the average spread of about 2 percentage points in the five years before credit markets began to seize in mid-2007.
The demand allowed companies to issue $353.6 billion of bonds last quarter, the most since the first three months of 2009, when they issued $381.1 billion, Bloomberg data show.
“The goal of quantitative easing is not to get interest rates to the lowest levels possible, it’s to get the expectations that rates will remain at these low levels for a long time to try to change investor behavior and get them investing in riskier assets,” said Ira Jersey, an interest-rate strategist in New York at Credit Suisse Group AG. The firm, which is also a primary dealer, is forecasting more purchases.
The central bank’s actions have raised investor expectations for inflation for 2015 to 2020 -- the so-called five-year, five-year forward rate calculated by the central bank -- increased to 2.6 percent last week after touching a near two- year low of 2.17 percent on Aug. 24. The rate, which is based on trading in Treasury Inflation Protected Securities, has averaged 2.6 percent the five-years before the financial crisis began.
“The harder the Fed pushes down on the accelerator and battles deflation through monetary tactics the higher inflation expectations will be in the future,” Schoenfeld said.
Assets held by the Fed have increased to $2.3 trillion from less than $1 trillion in September 2008. The cost of living in the U.S. climbed 0.3 percent in August for a second month as energy and food prices increased, while other goods and services showed little change, Labor Department showed on Sept. 17.
“This could be the last gasp of the 27-year bull trend in bonds that began with Paul Volcker squashing inflation expectations,” said William O’Donnell, head of U.S. government bond strategy at primary dealer Royal Bank of Scotland Group Plc in Stamford, Connecticut. “The Fed is actively working revive inflation expectations, a book stop to the Volker era. At the end of the day, central banks tend to get their way.”
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