Watch What We Do, Not What We Say

The Treasury market has responded to the improving US economic performance and a modest increase in inflation. The yield on the 10 year Treasury was 3.15% a month ago. Last week’s close in the 10 year was the third highest since last fall's financial collapse, when it briefly touched 2.04%. Since that low the 10 year had reached 4.00% in June and 3.89 % in August, after each peak dropping to 3.26% and 3.15% before recovering.

10 Year Generic Treasury Bloomberg

For the past ten months the Federal Reserve has been actively supporting the Treasury and mortgage markets with purchases of Treasuries and Mortgage Backed Securities (MBS). These programs are ending and the credit markets have taken notice.

Mortgage Backed Securities are essentially bundled mortgages that originating institutions sell to the credit markets to obtain the capital to make new commitments and to remove the original loan from their own books. This market had been moribund since the credit crisis last fall until the Fed commenced its purchase programs this past March.

Private participation in the asset back market and MBS in particular has been minimal. With the renewed emphasis on credit quality and balance sheet probity by the banks and their regulators it is an open question whether private institutions will be able to replace the volume of purchases from the expiring Fed programs. A distinct possibility is that the rates of the underlying mortgages will have to rise to attract buyers to the risk of the securities. If buyers do not come forth the funds available for mortgage lending will fall as banks are unable to generate additional cash by selling old loans to the market.

15 Year Chart 30 Year Fixed Rate Mortgage National Average (Freddie Mac) Bloomberg

In relation to the credit markets the Fed has been speaking and acting with the same purpose since the crisis began. It has targeted real rates with its various purchase programs and it has repeatedly warned that rates must stay low for an “extended period”. The two tracks of this rate policy are now beginning to diverge.

There was some anticipation before the last FOMC statement on December 16th that the governors might remove or modify the term extended period for the Fed Funds rate. That anticipation was premature. Extended period remained. The Fed Board and Mr. Bernanke are clearly not ready to state that the need for liquidity support for the US economy was over. But that is not necessarily the same thing as realizing that the continued provision of liquidity is detrimental to the return of self-sustaining private credit markets. Caution in public statements has been a hallmark of the Bernanke Fed.

The FOMC statement ended with a long list of special liquidity facilities, “most of which the Board of Governors anticipate will expire on February 1, 2010”. Why would the Fed include this list which is well know to the market and contains no new information?

Several things are happening at once. The US economy has left recession. Even if economic shrinkage returns sometimes in latter 2010, modest consumer spending, inventory rebuilding by industry and additional government stimulus will produce growth this quarter and probably for the first half of next year. Inflation has resurfaced, even if only in the most preliminary fashion. The Produce Price Index (PPI) soared from -4.8% year on year in September to +2.4% in November. Headline CPI has shot up from -2.1% year over year in July to +1.8% in November. The Federal Reserve prefers the core Personal Consumption Expenditure (PCE) price measure as a gauge of underlying inflation and it has been relatively stable. But the credit markets pay attention to all sources and signs of inflation in determining rates, whether Fed sanctioned or not.

As noted earlier the two-ten curve is the steepest on record. Longer rates are moving higher in response to economic and inflation considerations. Short terms are adhering to the Fed Funds target of 0.0%-0.25% The credit markets will not wait for the Fed to officially end its zero rate policy; nor will they require elaborate hints from government officials that excess liquidity and inflation are now the central bank’s concern. The Fed Governors know that the credit markets will boost rates with or without Fed encouragement.

The most important factors inhibiting dollar strength over the past six months have been the repeated insistence by Mr. Bernanke that US rates would stay low for an “extended period” and that he backed up this rhetoric with action in the credit markets.

The dollar could not benefit from the US Government response to the recession, despite the better historical record of American economic revival and accumulating evidence that the US recovery would be stronger (though not strong by standards of previous recessions) than Europe and Japan, because Fed rhetoric made it clear that it wanted rates low for that “extended period” and was doing what was necessary to keep them low.

The period of “extended period” has always been ill-defined, as was any indication of under what conditions the Fed would sanction rising rates. But the Fed does not set market rates. That was the primary reason for its entry into the Treasury and MBS markets. The Fed created those and other purchase programs was because it could not control the rates in those markets through the Fed Funds target. The reason those programs succeeded in keeping mortgage rates low is because they did not depend on Fed rhetorical prowess but on market actions.

The reserve is also true. Fed rhetoric will not be able to keep mortgage and other rates from rising if their purchase commitments are no longer available in those markets. Mr. Bernanke and the FOMC can repeat “extended period” as often as they choose-- without the purchases in the markets to back up their admonitions bond prices will fall and rates will rise. These facts are known to the Fed Governors.

In listing the expiring purchase programs was the Fed giving the credit markets a sign, ‘watch what we do, not what we say’? A mild American recovery and rising US rates, what else are 1st quarter dollar bulls waiting for?