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Enough of this “Bond-Markets-Don’t-Buy-Hawkish-Fed’s-View” Nonsense: It’s the Fed’s Reckless Interest-Rate Repression by Wolf Richter • Dec 20, 2021 • 210 Comments Bond Markets will buy Hawkish Fed’s views just fine if the Fed stops buying bonds, period, and sells outright its TIPS, MBS, and long-dated Treasuries. By Wolf Richter for WOLF STREET. The articles are everywhere, including today: “Bond Markets don’t buy hawkish Fed’s view on high U.S. rates can go.” They’re looking at the Treasury yields, particularly the 10-year yield which currently is at 1.4%, which is just a little higher than where short-term rates might be, according to the latest dot plot from the Fed by the end of 2022 and below where short-term rates might be in 2023. The theory is that bond markets are smart somehow and figure that the Fed won’t raise rates, or might cut rates into the negative or some such thing.
The reality is that the Fed already holds $5.64 trillion in Treasury securities, after its reckless bout of QE that started in March 2020. These holdings represent 25% of all marketable Treasury securities.
But this includes only $326 billion in short-term Treasury bills. The remaining $5.31 trillion are coupon-bearing Treasury notes and bonds. Of them, $1.02 trillion mature in 5-10 years, and $1.34 trillion mature in over 10 years.
With these enormous purchases and still growing holdings, the Fed has massively repressed long-term Treasury yields, which was the primary purpose of these purchases – to reduce borrowing costs across the board, from mortgages to junk bonds.
The interest rate repression scheme is even bigger: MBS. The Fed also holds $2.63 trillion in government-guaranteed Mortgage-Backed Securities, which, due to their government guarantees, trade with yields just a little higher than Treasury securities. And 97% of those MBS that the Fed holds mature in over 10 years.
MBS are different from regular bonds in that they pass the flow of principal payments through to their holders. These principal payments occur when a mortgage is paid off when the home is sold, and they occur when a home is refinanced and the existing mortgage is paid off, and they occur as monthly mortgage payments are made.
During the full-blast QE, which is now being tapered out of existence, the Fed purchased roughly $110 billion a month in MBS: $40 billion a month to add to the overall pile of MBS; and $70 billion to replace the pass-through principal payments.
By buying $110 billion a month in MBS, the Fed was the hugest gigantic-est and most relentless ravenous buyer ever in the MBS market. Nothing came even close. The Fed doesn’t trade; it only buys – unlike many other market participants that trade in and out of their positions.
By buying $110 billion in MBS a month, and by increasing its holdings by $40 billion a month, the Fed massively repressed not only the interest rates on mortgages, but also yields in the broader bond market. And that was the stated purpose of those MBS purchases.
The Fed purposefully falsifies the bond markets inflation signals. Part of the Fed’s Treasury security holdings are Treasury Inflation Protected Securities. The Fed holds TIPS with a face value of $381 billion and accumulated inflation compensation of $70 billion, for a combined $451 billion. Its holdings at face value represent about 20% of total TIPS outstanding.
With these TIPS purchases and holdings, the Fed has not only repressed the TIPS yield, but also has ingeniously manipulated the bond market’s “inflation expectations” data, that are based on the difference in yields from Treasury notes and TIPS with similar maturity dates.
So the often cited inflation expectation data coming out of the bond market, such as the “10-Year Breakeven Inflation Rate” (now at 2.38%), is not an indication of actual inflation expectations by the bond market, but what the Fed wants it to be.
Despite the Fed’s year-long and now abruptly abandoned efforts to brush off the worst inflation in 40 years, it must have expected back in 2020 and 2021 that there would be a lot of inflation as a result of its reckless money-printing.
And to be able to brush off this coming inflation for as long as possible without looking too ridiculous – an effort that failed as the Fed ended up looking totally ridiculous by summer – it preemptively manipulated the inflation signals coming out of the bond market with its proportionately large purchases of TIPS. It thereby purposefully falsified the very inflation signals that the Fed cited endlessly in its efforts to brush off the surging inflation.
The bond market will buy the Fed’s hawkishness just fine if the Fed allows it to. So we’re confronted with headlines like this: “Bond Markets don’t buy hawkish Fed’s view on high U.S. rates can go,” and similar.
But what bond yields reflect is what the Fed allows them to reflect. So in order to free the bond market from under the yoke of the Fed, and in order to allow it to signal what it really thinks, and to allow the bond market to buy the hawkish Fed’s views on how high rates can go, the Fed should:
If there is too much demand for yields to rise beyond a certain point, particularly demand from foreign buyers whose own sovereign bonds might still yield near 0%, the Fed should increase amounts of outright sales until the 10-year yield rises well above the rate of inflation. Blistering foreign demand would provide a perfect opportunity to unload the balance sheet for a perfectly timed exit.
- End QE cold turkey now, rather than in March.
- Allow all maturing Treasury securities to roll off the balance sheet without replacement, starting now.
- Sell outright, starting in January, those Treasury securities with a maturity of five years or more, starting with the longest-dated maturities, in large and unspecified amounts that are sufficient to allow the 10-year yield to rise well above the rate of inflation.
- Reduce MBS holdings by not replacing pass-through principal payments, and by selling MBS outright to where the combined reductions amount to about $120 billion a month. This will allow the Fed to wash its hands off these MBS in less than two years.
- Announce a policy shift, where QE is removed from the Fed’s toolbox forever.
And after the Fed starts actually shedding two or three trillions of its holdings in this manner, the bond market will start joyfully buying the Fed’s hawkishness, and yields will jump to where they belong with CPI inflation at 6.8%.
And as long-term yields shoot higher, the yield curve steepens, and the Fed can then raise its short-term rates rapidly to keep spreads at a reasonable level, while keeping the yield curve steep enough. And it will then gradually begin to accomplish the other task at hand: tamping down on this runaway inflation.
That’s what it would take to free the bond market to signal a reality outside the reckless interest-rate repression scheme designed and created of the Fed.
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