QE2's Fatal Flaw - Long Term Bonds

The Fed’s Fatal Flaw with QE2: Last week’s Fed moves to inject $600 billion into financial system over the next 8 months, also known as QE2, is flawed, and that flaw will come back to be the demise of the current monetary system as we know it. The flaw comes from the Fed’s unwillingness to purchase treasuries with maturities out beyond 10 years. At the time the Fed’s QE2 announcement was made, the Federal Reserve Bank of NY published a list of which parts of the yield curve the Fed would be purchasing from. The distribution is largely (86%) between 2.5 and 10 years, with maturities above 10 years representing only 6% of all purchases.


The reason why this will be a problem down the line is that the Fed is not going to bully the long end of the market into submission, as it has with shorter term rates. Since late August, the spread between 10 and 30 year treasuries has widened by over 50 bps, reflecting increased inflation expectations. These inflation expectations are also embodied in the change of pricing of longer maturity TIPs, as I illustrated in my November 3rd blog, as the difference in yield spread between 30 year treasuries and 30 year TIPs indicates a 50 bps increase in 30 year inflation expectations over a similar time period. My concerns are that at some point in time, the combination of inflation expectations, as well as concerns about the US’s ability to service its debt, without monetizing it, will also come into focus.


To illustrate my concerns, I want to compare what the Fed did in the 1940s versus what they are doing today. In the 1940s, in order to support the war effort, the government began an active campaign to raise money from the general population. And since there was a war going on, people’s propensity to save was going up, as the war time environment was not conducive to overt consumption, or for starting new, non-war related businesses. During this time period, the Fed implemented an interest rate cap, with a rising rate structure as the maturities went further out. This was to give Americans a level of confidence that interest rates were not going to rise, and it was OK to lend longer term money to the government.  Implementation of this rate cap was accomplished by purchasing treasuries of any maturity at the published rate cap. All it took for this plan to succeed was for the Fed to be there on a few occasions. After that, the bond dealers quickly learned they could front run the Fed’s rate cap, knowing that the Fed had a hard put in place. As with today, when the Fed buys securities, they are putting new money into the financial system. I am not sure if the Fed sterilized these operations by draining reserves by other methods in the 1940s, or not, but it is clear that today’s purchases of treasuries will inject new money into the system, or will go un-sterilized.


The beauty about what the Fed did in the 1940s, is that their actions put a hard cap on interest rates, and the lack of a rate cap today will be the downfall of QE2. I say this because the Fed opened the door for the market to express its dissatisfaction with the inflationary consequences of QE2, as the increase in the 10/30 year treasury spread. In contrast to the late 1940s, when there was 25 consecutive months which had CPI readings above 8%, and a 2 year average of 12.5%, while long term interest rates remained capped at 2.5%. What do you think would happen to long term interest rates if we even ran a 5% inflation rate?


Assuming the Fed capped rates, then this would have eliminated the ability of the markets to protest their moves. This will come into play when we do not do anything satisfactory about our budget deficits over the next one to three years. Instead, the Fed is allowing an environment in which the market is allowed to register a strong protest, and this protest will be found in the spread between 10 and 30 year treasuries, and to a lesser extent, between 5 and 10 year treasuries.


Now, I am not saying that inflation is going to be raging anytime soon, and in fact, I have presented my thesis that deflation will remain much more of a concern, than inflation, especially over the next year or two, especially when this nation’s excess (and defaulted mortgage) housing stock is allowed to be sold into the market. 


My take-away is that the Fed is opening the door for the bond markets to register a vote of no confidence towards the collective policies of easy money and large budget deficits. Perhaps the limitation on longer dated (over 10 year) maturities which the Fed will be purchasing for their latest QE moves, was the concession which QE advocates had to make to get the other voting members of the FOMC to agree to these moves. 


From where I sit, I consider this a very dangerous situation, since once the market moves our long term debt yields above a certain threshold, then the viability of the US will be called into question, as an 8+% yield on 10 year Irish debt casts a long shadow over the viability of Ireland to operate.  Clearly, this will be a problem for a later day, but nonetheless, when it does become a problem, it will be a big problem. As a note, I am not saying the Fed should necessarily be buying long bonds, as I also think that QE2 will prove to have created more harm than good. My point is that if the Fed is going to do something as foolish as QE2, then they will also be served to limit the ability of the market to protest their moves.


When will these problems come home to roost? And which indicators will we need to look at to show us that US debt costs are threatening the viability of the US? The simple answer is to watch 30 year and 10 year treasury yields, whose long term graphs I have on the attachment. When the yields on both of these instruments rise above their respective trend lines, then you will have a good indication that we are well on our way towards much higher interest rates. We could be on our way now, but this has not been confirmed by yields, yet.


The first graph of 30 year rates shows the basic trend line resistance at 4.73%. I inserted the yellow dashed line to show that even if a trend line is broken by a modest amount, that it is possible that such a break would be a false signal. Because of that, I would also look for 30 year yields to exceed their recent resistance levels, 4.88% and 5.33%, as the two green horizontal lines denote.


The second graph shows 10 year treasury rates over the same time period, and it appears that the 10 year, at a 2.68% yield currently, would need to rise above 4.44% to break its trend line resistance. The first trigger will be when 30 year rates rise above their trend line, which is much closer than with the 10 year treasury. Hopefully we will have other triggers, prior to confirmation that 10 year rates are rising above their channel, because it is a long way from 2.68 to 4.44% to wait.


The G20 meeting concluded earlier today, and among the press release, about halfway into it, was a section that affirms the “No firm is too big to fail”. To follow-up on the situation with Ireland, which I summarized in Wednesday’s blog, what happens when a country, such as Ireland, agrees to bail out its banks, when such an action jeopardizes the fiscal health of the nation? As was the case with Iceland, Ireland’s banks losses are now on the backs of the government. Ireland had a chance to push the losses onto the backs of the banks bond holders, as the Too Big to Fail doctrine says is supposed to happen. Wake up Europe!


A reader adds this comment about what is going on in Europe as it pertains to the Irish debt crisis:


“Here’s what’s triggering this second round in Europe: on Oct 29 the Euro states in a grand bargain, agreed to open the Lisbon treaty to include a support mechanism to deal with future problems.  To get the Germans to go along, a bail-in clause would have to be included.  This clause will require only private holders (not govt holders) of sovereign debt being restructured to absorb the losses.  The unintended consequence of this is every time the ECB buys debt of problem nations, the remaining private holders of the debt are being structurally subordinated.  Taken to its logical conclusion, private investors will continue to sell bonds, spreads will widen, the ECB will buy bonds and the cycle will continue until the ECB owns all the bonds and ultimately won’t be able to avoid taking the losses.  Talk about an Irish hot potato!” (end of reader’s comment)


This reader then asked me: “Have you seen the movie Dumb & Dumber & the ECB,” to which he added, that before this mess is done, there will be more sequels than the Freddie Movies! 


* G20 redux: On average, the G20 meetings produced very little. It is remarkable how much disagreement there is in each country’s foreign ministers post G20 statements. Bloomberg users can type NI G20 <go> to see the line-up of conflicting opinions.