Watch What We Do, Not What We Say

Pay attention to the bond market. The ten year Treasury closed at 3.80% on Friday. It has risen 0.65% since November 27th. The yield curve difference between the two and ten year Treasury notes is the steepest on record. Thirty year fixed mortgages were 5.28% on Friday, up 0.32% in a month; six months ago the rate was 5.51%, a year ago 5.36%. A fifteen year historical average for a thirty year fixed home mortgage is close to 7.0%

The Treasury market has responded to the improving US economic performance and a modest increase in inflation. The yield on the 10 year Treasury was 3.15% a month ago. Friday’s close in the 10 year was the third highest since last fall's financial collapse, when it briefly touched 2.04%. Since that low the 10 year had reached 4.00% in June and 3.89 % in August, after each peak dropping to 3.26% and 3.15% before recovering.

For the past ten months the Federal Reserve has been actively supporting the Treasury and mortgage markets with purchases of Treasuries and Mortgage Backed Securities (MBS). These programs are ending and the credit markets have taken notice.

Mortgage Backed Securities are essentially bundled mortgages that originating institutions sell to the credit markets to obtain the capital to make new commitments and to remove the original loan risk from their own books. This market had been moribund since the credit crisis last fall until the Fed commenced its purchase programs this past March.

Private participation in the asset back market and MBS in particular has been minimal. With the renewed emphasis on credit quality and balance sheet probity by the banks and their regulators it is an open question whether private institutions will be able to replace the volume of purchases from the expiring Fed programs. A distinct possibility is that the rates of the underlying mortgages will have to rise to attract buyers to the risk of the securities. If buyers do not come forth the funds available for mortgage lending will fall as banks are unable to generate additional cash by selling old loans to the market.

In relation to the credit markets the Fed has been speaking and acting with the same purpose since the crisis began. It has targeted real rates with its various purchase programs and it has repeatedly warned that rates must stay low for an “extended period”. The two tracks of this rate policy are now beginning to diverge.

There was some anticipation before the last FOMC statement on December 16th that the governors might remove or modify the term "extended period" for the Fed Funds rate. That anticipation was thwarted. "Extended period" remained. The Fed Board and Mr. Bernanke were clearly not ready to say that the need for liquidity support for the US economy was over. Does the board have economic or financial concerns unknown to the wider markets? Probably not. Caution in public statements has been a hallmark of the Bernanke Fed.

However the FOMC statement ended with a long list of "special liquidity facilities", “most" of which "the Board of Governors anticipate will expire on February 1, 2010”. Why would the Fed include this list which is well know to the market and contains no new information?

Several things are happening at once. The US economy has left recession. Even if economic shrinkage returns sometimes in latter 2010, modest consumer spending, inventory rebuilding by industry and additional government stimulus will produce growth this quarter and probably for the first half of next year. Inflation has resurfaced even if only in the most preliminary fashion. The Produce Price Index (PPI) soared from -4.8% year on year in September to +2.4% in November. Headline CPI has shot up from -2.1% year over year in July to +1.8% in November. The Federal Reserve prefers the core Personal Consumption Expenditure (PCE) price measure as a gauge of underlying inflation. But the Fed does not set market interest rates and the credit markets pay attention to all sources and signs of inflation.

As noted earlier the two-ten curve is the steepest on record. Longer rates are moving higher in response to economic and inflation considerations. Shorter terms are adhering to the Fed Funds target of 0.0%-0.25% The credit markets will not wait for the Fed to officially end its zero rate policy; nor will they require elaborate hints from government officials that excess liquidity and inflation are now the central banks concern. The Fed Governors know that the credit markets will boost rates with or without Fed encouragement.

The most important factors inhibiting dollar strength over the past six months have been the repeated insistence by Mr. Bernanke that US rates would stay low for an “extended period” and that he backed up this rhetoric with action in the credit markets.

The dollar could not benefit from the US Government response to the recession, despite the better historical record of American economic revivals and accumulating evidence that the US recovery would be stronger (though not strong by standards of previous recessions) than Europe and Japan, because Fed rhetoric made it clear that it wanted rates low for that “extended period” and was doing what was necessary to keep them low.

The period of “extended period” has always been undefined, as was any indication of under what conditions the Fed would sanction rising rates. But the Fed does not set market rates. That was the primary reason for its entry into the Treasury and MBS markets. The Fed created these and other purchase programs was because it could not control the rates in those markets through the Fed Funds target. And the reason those programs succeeded in keeping mortgage rates low is because they did not depend on Fed rhetorical prowess but on market actions.

The reserve is also true. Fed rhetoric will not be able to keep mortgage and other rates from rising if their purchase commitments are not available in those markets. Mr. Bernanke and the FOMC can repeat “extended period” as often as they choose-- without the purchases in the markets to back up their admonitions prices will fall and rates will rise. These facts are known to the Fed governors.

In listing the expiring purchase programs was the Fed was telling the market watch what we do not to what we say? A mild American recovery and raising US rates, what else are 1st quarter dollar bulls waiting for?

Joseph Trevisani

FX Solutions

IMPORTANT NOTICE: These comments are for information purposes only. Past results are not necessarily indicative of future results. Trading Futures, Options on Futures, and Foreign Exchange involves substantial risk of loss and may not be suitable for all investors. You should carefully consider whether trading is suitable for you in light of your circumstances, knowledge, and financial resources. You may lose all or more of your initial investment. Opinions, market data, and recommendations are subject to change at any time. The information contained on this email does not constitute a solicitation to buy or sell by FX Solutions,LLC., and/or its affiliates, and is not to be available to individuals in a jurisdiction where such availability would be contrary to local regulation or law.

(Chart courtesy of FX Solutions' FX AccuCharts. Price on 1st pane, Slow Stochastics on 2nd pane; uptrend lines in green; downtrend lines in red; horizontal support/resistance lines in yellow; 200-period simple moving average in light blue.)