Tuesday, May 26, 2009

The Interest Rate Problem of the Federal Reserve

The “Bond Fears” in today’s Financial Times could be the epilogue to my 3-part series on the international monetary relations. (I do not provide a link because you need to subscribe to FT to read this particular article.) After pointing out that the yield on 10-year treasuries had gone up 26 basis points in two day, the article asks:
What’s going on? The fall in equities is scary but comprehensible. Not so with the bond sell-off … Fixed-income investors are now genuinely bewildered. The long-term trend, the latest inflation data, not to mention the experience in Japan, all point to lower yields. Buying by the Fed is another reason to favour bonds. But this latest sell-off, taken alongside the weakness of the dollar, suggests something far more terrifying is causing sleepless nights.
What is going on is this: The Fed is trying to resolve an economic crisis by means of technical maneuvers. Whether this is due to an “invincible faith in oneself”, a profound ignorance of economic relations or the absence of any other policy option, matters not. The result is the same. The bond yields are going up (and bond prices down) when the opposite is supposed to happen. That is how you know a force more powerful than the Fed’s is at work.

I will return with more on this.