Dollar Bears Still Focused on Treasury Meltdown

US Treasury yields are surging. The 10-year note yield is now up 27 bp on the session at 3.72%. Several factors are weighing on US yields today. The ISM report, coupled with the the better readings in Europe and China, keeps the greenshoots story intact. Various measures of the tensions in the financial markets have eased. There are annecdotal reports of portfolio shifts from fixed income to equities. There are of course also concerns about supply.

Back at the March FOMC meeting the Federal Reserve decided to purchase $300 bln of Treasuries in the following six months. To date it has purchased a little less than half this amount. It has indicated it will buy 7-10 year maturities on Wed and 2-3 year maturities on Thurs. Next week it will make two purchases, 4-7 yrs and 10-17 yrs.

Since the end of March, foreign central banks have bought nearly as much Treasuries as the Federal Reserve. The Fed appears to have purchased a little less than $150 bln, while the Fed's Treasury holdings for foreign central banks has risen about $127 bln since the end of March.

The April FOMC minutes suggested that Fed officials are open to increasing its asset purchases, depending on financial and economic conditions. The 10-year Treasury yield is about 100 bp higher than then it was when the Fed first announced its Treasury purchases. Many of the so-called bond vigilantes suspect that if yields continue to rise, the Federal Reserve will be forced to step up its purchases of Treasuries. Yet, even those countries like the UK and Japan which are buying a larger fraction of this year's new issuance, have seen yields rise sharply. It is not clear that simply buying more Treasuries will hold down rates, if that is the main objective.

Mortgage rates appear to be rising and the 30-year fixed rate mortgage rose above 5% last week. Yet the Federal Reserve have bought hundreds of billions of dollars more of mortgage-backed securities and agency bonds than Treasury. The Fed's previously announced agency and MBS purchases are anticipated to run until the end of the year, whereas the Treasury purchases were to be completed in six months. While the Fed could announce an increase of its Treasury purchases sooner rather than later, perhaps in hope that its signalling device may succeed where its actual purchases have largely failed to keep rates low. On the other hand, some market participants suggest that given the potentially negative implications of even further monetization of the debt, such as boosting inflation expectations and undermining the dollar, the Federal Reserve may be loathe to announce an increase of its Treasury purchases until it needs to, i.e., when it nears completion of its $300 bln commitment. Instead, they suggest that the Fed could concentrate its fire power in certain parts of the curve--say 5-10 years rather than buying the short-end (2-3 years) or the long end (over 17 years).

In addition, the declaratory policy of the Federal Reserve suggests that its long-term asset purchases are not aimed at targeting an interest rate. Rather the goal of what it calls its credit easing (as opposed to quantitative easing) is to keep credit flowing to different market segments. The Fed seems to want to disabuse market participants from thinking that any yield level is a line in the sand that the Fed will defend. As officials have learned from the experience in the foreign exchange market, the defense of a fixed level is not very practical.

Of course, we should take it for granted that Fed officials are closely monitoring the credit markets. The next FOMC meeting is 3 weeks away on June 24. The Fed appears to be trying to resist begin delivered a fait accompli from the credit markets. As long as the bulk of the yield rise is on real rates and not in the expected inflation component (the 5-year/5-year forward is up 8 bp today), look for the Fed to continue with its current game plan