Wednesday, February 23, 2011

Quantitative Easing and The Treasury Market

The slide in treasuries continues again and it is clear the Fed has lost any control of the entire curve beyond a one year maturity.   Equity markets are at a very critical juncture right now with QE2 expected to end in June.  The reality is equity markets may very well begin pricing the end of QE in the near future, if you consider the Jackson Hole speech hinted at QE2 in August and saw equities price in the policy three months ahead of the November 2010 meeting.

There is no shortage of people calling for endless QE (easily 80% of those voices truly don't even understand QE).  The environment now though has changed making the options to Fed monetary policy more limited.  Probably the biggest headwind facing the Fed is rising interest rates.  The federal funds rate is at 0-25 bp and QE was intended to push down rates further out on the curve and it did work for a while.  The Fed conditioned all of us for low rates with their continual use of "extended period" with each FOMC statement.

The Fed needs to be careful moving forward.  The bond market has clearly signaled they are concerned about inflation, loss of confidence in the Fed and US fiscal policy.  The US is competing with other sovereign nations for capital at the same time they are increasing their supply with growing deficits.  Imagine a shock even to the US economy.  The US is in no position to use emergency stimulus without risk of truly blowing out yields.

Two Year Treasury

After catching a little bid last week the two year has given up all its gains and looks to test the lows again.  The shorter end of the curve had stayed relatively low in yield but has risen more than any other maturity recently causing a bear flattening (higher rates and a flatter curve).  Not favorable for banks or those on the wrong side of interest rate swaps (which is a $458 trillion market).

Ten Year Treasury

Has bounced along a multi year trend line after failing last week.  Looks like it too is set up for failure.  This is not good for housing which is already under pressure and double dipping.  A 100 bp rise in 10 year yield equates to about an 11% drop in home prices.


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