Reality check for U.S. bond binge
Here is the way it was supposed to work: Uncle Sam would borrow and spend trillions of dollars to save the economy and the financial system, but interest rates would stay near rock-bottom and nobody would worry about the potential side effects of all that spending -- like, say, inflation or a devalued dollar.
Things aren’t proceeding quite according to plan. The investors who are supposed to buy all of that new Treasury debt are rebelling, driving interest rates up.
That’s exactly what the housing market doesn’t need. The average 30-year mortgage rate rose to a six-month high of 5.29% this week from 4.91% the previous week, according to Freddie Mac.
And that was before Friday’s big jump in Treasury bond yields, which are the benchmarks for many other interest rates, including home loan rates and municipal bond yields.
The 10-year Treasury note yield rocketed to 3.86%, up from 3.71% on Thursday and the highest since November.
Compared with the many financial catastrophes of the last nine months -- the failure of Lehman Bros., the partial nationalization of Citigroup Inc., the bankruptcy of General Motors Corp., etc. -- a 3.86% yield on a Treasury bond would hardly seem to rank as a national tragedy.
But it’s the trend that’s important here, and the broader implications. Even as Federal Reserve Chairman Ben S. Bernanke was on Capitol Hill this week warning that the U.S. risks borrowing its way into yet another crisis, Treasury Secretary Timothy F. Geithner was in China trying to assure the largest foreign owner of Treasury bonds that its investment was safe.
Yet with every tick higher in market yields, the value of China’s $770 billion in Treasury holdings erodes.
In an editorial this week, the China Daily newspaper expressed fear that “Washington’s mushrooming deficit, generated by the massive government borrowing to fuel its economic recovery plan . . . will undermine both the dollar and U.S. bonds.”
Good thing Geithner left China before Friday, when Treasury yields soared after the government reported that the economy lost a net 345,000 jobs last month -- far less than the 520,000 that analysts, on average, had expected.
Even though the unemployment rate rose to a 25-year high of 9.4% from 8.9% in April because more people were looking for work, financial markets latched onto the job-loss figure as another sign that the recession is nearing its end.
We should all be thankful for that, of course. But here’s the rub: If the economy is getting better, investors assume that the Fed will at some point begin pulling back from its unprecedented easy-money policy by raising short-term interest rates from current near-zero levels.
And if short-term rates are going up, it would be hard for long-term rates to sit still. What’s more, a strengthening economy could raise the risk of higher inflation, which is Public Enemy No. 1 for owners of fixed-rate bonds.
Treasury investors don’t just make this stuff up on their own. Thomas Hoenig, head of the Fed’s Kansas City bank, this week said the central bank must be poised to begin lifting short-term rates, asserting that “If we fail to bring policy into balance, we will have significant inflationary pressure.”
At the same time, even as the Obama administration pays lip service to eventually reining in federal borrowing, the supply of bonds keeps ballooning to fund deficit spending. Next week the Treasury will auction a total of $65 billion in three-, 10- and 30-year bonds.
Now, it’s worth asking why any bond investor would have assumed that interest rates could stay down once the economy began to revive. The normal pattern, after all, would be for rates to rise.
Yet the Fed itself has encouraged the idea that this time would be different, given the twin disasters of the deep recession and the financial-system meltdown.
In the case of short-term rates, the Fed’s official line has been that it would keep them at “exceptionally low levels . . . for an extended period.”
In a far more controversial move, the central bank late last year decided to use its own resources to try to manipulate long-term interest rates.
First, the Fed began buying mortgage-backed bonds in an effort to keep home loan rates down. And in March, the Fed committed to buying $300 billion in Treasury securities over six months, hoping to restrain bond yields in the face of the Treasury’s borrowing binge.
Yet longer-term Treasury yields have been moving up almost relentlessly this spring, despite the Fed’s purchases.
Some investors say the experiment was ill-advised and is adding to the bond market’s sense of unease.
“It’s ridiculous,” Jeffrey Gundlach, chief investment officer at money manager TCW Group in Los Angeles, said of the Fed’s attempt to hold down Treasury yields.
“You can’t bail yourself out.”
There is another school of thought here that should offer investors some comfort: Treasury securities have lost their appeal in part because investors are feeling better about the economy and are putting their money into higher-risk assets, including stocks, commodities and junk bonds, in search of higher returns.
Still, because other interest rates key off Treasuries, turmoil in that market can’t be blithely ignored -- least of all by the housing market.
More worrisome is that a sell-off in Treasuries is equated (rightly or wrongly) with a rejection of the dollar and an indictment of U.S. monetary and fiscal policy.
On multiple levels, Uncle Sam just can’t afford to have an image problem with his IOUs right now.
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