The Federal Reserve-Treasury Accord of 1951 freed the Fed from its responsibility to fix yields on Government debt. Prior to that agreement, the Fed had maintained a ceiling of 2.5% on long-term Treasury bonds for nearly a decade. The Fed had also maintained a ceiling on the twelve month Treasury certificate of between 0.9% and 1.25%.
According to a speech by Mr. Bernanke, the Fed was able to achieve these lower interest rates despite the debt to GDP being at higher levels and inflation being dynamic during the decade.
Post the Federal Reserve-Treasury accord, there was no discussion or evidence of the Fed again trying to impose ceilings on long-term treasury bonds.
I thought that discussing this topic would be interesting at a time when the CPI-U index in the US has increased by 2.9% over the last 12 months. Further, food prices have gone up by 3.1%, the gasoline index is up by 12.6% and the fuel oil index is up by 8.9% in the last twelve months. Globally also, inflation is on the higher side with rising commodity prices and the impact of easy monetary policies.
In contrast to all this, the yields on 10-year Treasury bonds is at 2.27% and the yields on 30-years Treasury bonds is at 3.36%. Is the risk in the system so high that people are rushing to buy government bonds or is there some other force at work to keep bond yields artificially low?
There is no doubt that there are risks in the financial system. At the same time, there is a certainty that Central Banks in US and Europe will keep interest rates low for a relatively long period. This encourages speculation in other asset classes and there is a flow of money out of less risky assets to more risky asset classes. However, this is not reflected in the bond yields.
Further, as mentioned in the chart, the bond yields are currently near levels witnessed during the Lehman collapse. Is the risk in the financial system so high? Spreads and other indicators don't suggest that for the foreseeable future.
Clearly, there is some other factor at work, which is keeping bond yields at lower levels. In my opinion, it is the ceiling imposed (unofficially) by the Fed on longer-term bond yields.
This brings us to the next important question. Is it possible for the Fed to keep yields on longer-term bonds artificially low?
It is very likely in my opinion and more importantly, it is possible according to Mr. Bernanke.
This idea, in the words of Mr. Bernanke has already been implemented in the US. The Fed has committed to keep interest rates at lower levels until 2014. I must mention that we are already in the third year of near-zero interest rates.One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates.
Also, in the words of Mr. Bernanke again -
The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.
In one of my earlier articles, I have talked about the major buyers of US debt in the last two years. Not surprisingly, the biggest buyer of US debt has been the Federal Reserve. If these purchases are in line with the above strategy mentioned by Mr. Bernanke, the success can already be seen in the form of lower bond yields.
Buying medium-term treasury securities is an indirect method of lowering long-term bond yields. It is also likely that the Fed has been directly influencing yields of longer dated bonds. However, I have no evidence to prove this point and therefore I just classify it is a suspicion. At the same time, I am not saying this just out of suspicion. It is very much there in the list of Mr. Bernanke's ideas to lower yields on longer-term securities.
Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).
Mr. Bernanke has talked about 3 to 6 year bond yields. But it could easily mean directly influencing 10-year bond yields as well.
The objective of this article is not to point fingers at the Fed or Mr. Bernanke and suggest that there is high degree of manipulation going on in the system. It is more to analyze if longer-term dated Treasury securities are really worth buying for foreign investors? Especially for countries like China and India where inflation is significantly higher and the returns on long-term bonds is negative (adjusted for inflation). Therefore, I am not surprised to see China's total holdings of US bonds remaining largely constant in the last 20 months.
If the case of ceilings imposed on Treasury bonds be true, one can expect a prolonged period of artificially low interest rates. In such a scenario, one will lose on purchasing power by being in cash or having deposits in banks. Therefore, from an investment perspective, it is advisable to have exposure to equities, commodities and gold. Real interest rates might remain negative for the coming decade or more.
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