I have noticed a lot of media coverage about the rising treasury yields. The situation is portrayed as something the Federal Reserve policy makers do not want. In reality, itâs quite the opposite. Since the Federal Reserve is the sole provider of mortgage credit in the United States now, they have total control over mortgage rates. The rise in treasury rates is driving mortgage rates higher temporarily due to hedging pressures by banks. Once the treasury yields reach their normalized target, mortgage rates will fall quickly. Continued: in next thread.
The rise in the yield curve is what fed is trying to produce. They were pushing as hard as they could with policies to get the cash out of treasuries. The only way to get the financial system to work again was to get all the trillions of cash sitting in treasuries to move back into the debt markets. There was a huge flight out of risk to treasuries worldwide. The massive treasury rally in November is the result. If you have been watching, as the yields on the longer term treasuries have been normalizing (rising to a more normal level) you have seen massive cash going into commodities, equities, and the debt markets. From my perspective one of the reasons the fed publicly revealed their treasury purchases was because they knew that it would spook some of the cash out. With the fed funds rate at 0, there is a huge motivation for cash holders get out of cash, but it wasn't working. The public announcement of treasury purchases did work. The current deflation was caused mainly by all the world's cash reserves piling into treasuries due to fear. Holding risk free treasuries, from September, until April, was the only investment central banks, sovereign wealth funds, hedge funds, and others would hold. The flight to treasuries was contracting the money supply within the financial system. The world is awash in dollars, but fear was overwhelming rationality. Now, as the fed kicks cash out of treasuries, the dollars flow into the markets and we see much more normalization in financial system. Lastly, as the long end rises, the yield curve steepening is very bullish. Banks are making a killing right now, similar to 2002-2003. They can borrow at essentially 0 and lend out at 5-6%. Who wouldn't want to lend in this environment. The problem of credit contraction is essentially over. All the talk about this being a problem is propaganda. The fed wants the steep yield curve to help the banks earn their way through this fiasco. The long end wouldn't budge until the fed started "publicly" buying treasuries. The fed has been in the treasury market since the creation of the dollar/debt system, but most investors don't understand this process. The guys at the fed know this, and they know that publicly announcing what they have always done may create a greater fear of inflation, than a fear of deflation, so market psychology will seek out more risk. As far as the National debt: Due to the dollar/debt based financial system, the only way to increase the money supply, is to issue/create treasuries. The government prints the treasuries; the fed can then buy those treasuries with dollars, which pumps new cash into the system. That is the reason Bernanke was pushing congress to pass an economic stimulus package. It didn't really matter to the fed how the package would be dispersed. They just needed the 700 billion in treasuries printed, so they could inject dollars into the world financial system. With the world dollar standard, the only way to expand the worldwide money supply was to create massive amounts of treasuries, so the fed could buy them to inject billions of dollars into the interbank market. Foreign central banks must buy dollars with their currencies since international trade is mostly settled in dollars (this is changing a bit in Asia due to China). That is why the dollar was very strong in the first half of the year. There was a dollar shortage due to the majority of dollars parked in treasuries. This dollar standard gives the Anglo Saxon economies huge power over world growth and trade. That is why there may be talk of moving from the dollar standard, but in the back rooms, there will be huge power struggles. China, Russia, and other countries were very angry about the dollar shortage in the summer and fall of '08. They realized that the dollar standard has total control over their economies. They could not decouple from the collapse, even though they had huge dollar reserves. World trade essentially froze up. No one could get credit for shipping containers; there were no dollars to buy commodities, etc. China and Russia didn't want to waste their reserves trying to prop up their trade interests, because they probably would have taken huge losses. China knows that the US is going to inject massive new dollars into the world system to re-ignite growth by forcing dollar holders out of cash. That's why they have been expressing their worries. They know they hold too many dollars to diversify out of cash aka treasuries. China policymakers are very conservative, so after losing massive amounts from FNM and FRE, and US banks, they have vowed to stay away from US equities and corporate debt. If china tries to diversify out of treasuries, 2 trillion will create huge imbalances in those markets, which could collapse their economy. Treasuries are the only liquid vehicle big enough to absorb the large dollar flows. But, China is trapped by their currency policy. They have built up these huge reserves by pegging to the dollar and dumping their goods below value to US consumers. They thought with their reserves they would be immune to the Federal Reserve's policy, but they are stuck with paper dollars, whose value is subject to Federal Reserve policy. China exacerbated the US economic crisis by dumping their equities and fleeing to treasuries and commodities last year. They are now trying to dictate US government policy through the debt market. By owning only treasuries, they use the threat of dumping them as a way to influence Washington economic policy. Washington Policymakers don't understand how the treasury market really works, so they are falling prey to the fear mongering from China about a large national debt. But the Federal Reserve is independent from Washington and holds the power to the currency value and monetary policy. That's why you have seen these new House Resolutions (H.R. 1207) from Congress to get more control over the Federal Reserve. This is highly unlikely to get much traction. The international banks and corporations that are shareholders in the Federal Reserve system have a much more powerful lobby in Washington. At the same time, the Federal Reserve is trying to force Chinese policy makers to open their capital account with this massive monetary expansion. The Federal Reserve wants a floating renminbi, so China can be subject to the dollar business cycle through international banks. China is trying to create a way around this through alliances, and currency swaps. But there is no option. Dollars are flowing out of treasuries and China is sort of the bag holder. If treasuries keep falling, they will lose massive amounts of reserves. The only thing that gives China its economic power right now is their huge reserves. But, alas, they are dollars. There is a power struggle in the financial system between the US and China, and Russia. China and Russia want to be exempt from the Federal Reserveâs policies. Even if somehow China makes the renminbi a reserve currency, oil is still priced in dollars due to the US/OPEC agreement. Russia does not want the renminbi, they want the Ruble to be a reserve currency. So, who will China buy oil from? Brazil seems to be the only participant. OPEC knows what happened to Iraq when they were trying to price Oil in Euros. Iran has moved to Euros, but they are dealing with the daily pressure from US policymakers and the economic sanctions.This was a small concession to Europe after the US invaded Iraq without the EU's support. So, it's highly unlikely that the oil/dollar pricing will change. Europe is essentially neutral in this. They prefer the dollar standard because they have a world view similar to the US and they are allies. The Euro and the dollar have a symbiotic relationship in the interbank market via the Eurodollar. Germany has a close relationship with Iran, which is why the US has allowed Iran to price oil in Euros. It gives Europe an assured supply outside of the Federal Reserve dollar policy. But, Iranian policymakers hate that they have western banks controlling their economy and oil reserves. So, they have been trying to get nuclear weapons. European energy supply would be devastated by this, so the US and Europe keep pressure on the Iranian leaders not to develop the bomb. But Germany supports the Iranian nuclear power industry, because this allows Iran to use less of its oil reserves and it frees up more oil for export to Europe, especially Germany's power hungry export sector. The ECB has a different mandate than the Federal Reserve. Their policy has a smaller impact on the world financial system, so they hedge against Federal Reserve policy during monetary expansion. Europe still has the old monarchs and very old money. These families want their buying power and wealth protected. So, the ECB has an explicit strong currency policy. They, by mandate are not allowed to dilute the money supply the way US policy does. But again, the dollar must regulate worldwide growth, and commodity prices. Continued:
The main thing to watch is how China deals with their capital account. If they open it and allow the currency to float, they will be submitting to the dollar system. China cannot create the renminbi as a reserve currency without finding a reliable source of oil that will be priced in renminbi. If Russia were to accept the renminbi, that could be a huge risk to the dollar. But the Russians don't want to submit to the Chinese. So, there are many large obstacles for the Chinese. Right now, they are at the mercy of fed expansionary policies, and are seeing their reserves losing value. They have been buying a lot of commodities to diversify, but the problem is, they are still at the mercy of the dollar. If the fed deflates the world dollar supply, China's commodity reserves would lose value. Commodities are illiquid, and can only be used in barter exchange, or sold for a currency acceptable in world trade. They could just go back to investing in US equities and debt markets, and take a share in the US recovery. But, China has much greater ambitions. (End)
Excellent thread, Pascal. Thank you for posting it. How do you suppose China will control it's population now with a pandemic of Consumeritis (a virus for which there is currently no known cure) spreading unchecked?
Good thread. Taking the "Devil's Advocate" side, who's to say the government is in control of the longer term treasury yields? Couldn't this be the market working to offset credit and inflation risk by demanding a higher yield on the longer maturity treasuries? And also the never ending treasury auction sales have a yield increasing effect as well. The banks may make a larger spread from the short to long yield differential, but the volume of the loans made by banks will really shrink, possibly offsetting all or more of the gained margin on the spread. I don't see the U.S. as invincible when it comes to borrowing money, so maybe that's where the error of my thinking comes in trying to believe your main theory; that the government is encouraging higher long term treasury yields...hmmm
That is not always valid. There is a case when rates are considered too low by the market and inlationary expectations are rising and the yields will start to rise as well. If the Fed try to counter it by buying more treasures it will lift inflation expectations and the yields will rise even more. At this level, the money that the Fed pumps will start to backfire and the more the pumping the bigger the nominal yield will get. In this case Fed has lost control of its monetary policy and is officially markets hostage.
As in the past, when dollar confidence falls in the international financial system, inflationary forces become prevalent. In the 70âs OPEC did not support US policy towards the middle-east and the support for Israel. This created a dollar crisis that lead to a decade of low dollar confidence, which created high inflation worldwide. In the late 70âs Federal Reserve officials sensed an imminent dollar crisis, so they called in dollar loans worldwide, and squeezed liquidity with painfully high short term interest rates. The dollar system is built on recycling. The US buys large quantities of international exports by creating easy credit for American consumers. The largest of US imports is crude oil. Since Bretton woods, the system is based on dollar flows. The US buys energy products, exports food commodities, and imports consumer products. US financial institutions finance these transactions. The system can only work properly with a continuing flow of dollar recycling. The export countries receive these excess dollars, since the US operates on a current account deficit, then re-invests them into the US financial account. The excess dollars recycled into the US financial account, fills the gap created by the current account deficit. In laymans terms, the US buys more than it sells, but the system works because the sellers continually re-finance the US with their dollars they receive for payment. The US financial institutions then recycle these excess dollars by financing the growth in emerging markets. This system creates enough liquidity to keep the world economy growing . The system is flawed though, in that it has short-term vulnerabilities. It is vulnerable to political instability due to bad short-term policy by Washington politicians. The Federal Reserve utilizes free market forces to correct these political forces. For example, if populist representatives are elected to Congress, they can create protectionist policies that constrict the flow of dollar recycling. The US economy will experience rising interest rates, or rising commodity prices. This would slow the US economy and by the next election, these representatives would be removed from office. Sometimes, though, longer term forces can be a catalyst to a loss in dollar confidence. The federal reserve has large blunt tool that it uses when this is the case. In the case of the 70âs high inflation, the federal reserve used the blunt tool by raising short term interest rates and calling in dollar loans to contract the money supply. Paul Volker is known for killing inflation. But inflation was not really the problem, flight from the dollar was. The dollar recycling process had stopped due to overwhelming world political pressures. The Federal Reserve is independent, but at times of US weakness, is willing to use their financial weapons. The contraction in worldwide dollar markets in the 1980âs squeezed all the excess liquidity out of the world financial system. No major US trade partner had excess reserves to defy the dollar standard by 1982. This set the stage for 2 decades of relatively benign inflation rates and robust US economic growth. We are now again in a situation where the dollar standard is threatened and the recycling engine is clogged. (continued)