The Fed, Treasuries, and Mortgage Rates

It was an interesting day in the markets even though gains were modest. Tonight I want to discuss treasuries, mortgage rates, and the Fed's dilemma. I know this sounds really exciting!(not) However, I think you will find it helpful in terms of understanding whats going on in the markets right now.

There is a ton of maneuvering going on behind the scenes as the Fed tries to prevent this debt bubble from bursting. The easy first response from the Fed when this crisis first hit was to slash rates, and provide a ton of liquidity to the financial system. The Fed hoped that this would stimulate lending and borrowing and keep the economy going.

So how did that work?

As we all know, the results are not impressive. So what have been the repercussions of the Fed cuts?

In a nutshell: Higher food inflation, a weaker dollar, $130 oil, and mortgage rates that are basically within a 1/4 point from where they were when the rate cutting began. Pretty impressive isn't it? Ha Yea right.

The Fed decided to switch gears after this experiment failed and started providing liquidity by other means. Examples of this are the discount window where the financial institutions including investment banks could use AAA bonds as collateral to borrow cash at a discounted rate.

They also started up Lending Facilities that allowed the banks to use other forms of AAA debt like student loans for collateral to borrow additional money.

So where are we now?

Well throwing all of this liquidity into the system has its reprocussions. We have created a whole set of problems that has really put the Fed in a bad spot. With liquidity comes inflation. This is problem number one.

Problem #2: You can't throw all of this liquidity at the financial system without paying for it. The Fed does this through holding auctions and selling things like 2 and 5 year treasury bonds. There is a $60 billion dollar sale that began today.

So how are the auctions going?

From the looks of Bloomberg today demand looks to be slow. The central banks of the world are growing tired of buying these Treasuries that continues to get devalued by inflation and our weak dollar.

As a result, the yields must rise in order to make them attractive to investors. Here are some highlights from Bloomberg:

May 28 (Bloomberg) -- Treasuries fell, pushing the 10-year note's yield above 4 percent for the first time since January, as a measure of durable-goods orders unexpectedly rose and the government's two-year note sale was met with tepid demand.

Bonds extended their losses after the auction of $30 billion of the securities drew a higher yield than bond-trading firms forecast and attracted the lowest level of demand since February from a group that includes central banks. The government will sell $19 billion of five-year notes tomorrow.

The yield on the current two-year note rose 12 basis points, or 0.12 percentage point, to 2.62 percent at 4 p.m. in New York, according to BGCantor Market Data. It was the highest level since Jan. 11. The price of the 2.125 percent security due in April 2010 fell 7/32, or $2.19 per $1,000 face amount, to 99 2/32.

The benchmark 10-year note's yield increased 11 basis points to 4.03 percent. It's the highest level since Jan. 2. The security's rate is 1.40 percentage points higher than that on two-year notes, compared with 1.54 percentage points when the government held the last two-year note auction on April 23.

In the government's sale of two-year notes, indirect bidders, the category of investors that includes foreign central banks, bought 22.4 percent of the auction. In the past six sales, the group bought 24.9 percent on average.

Fed Rate Outlook

Futures on the Chicago Board of Trade indicated a 73 percent chance the central bank would increase its target rate for overnight lending between banks by at least a quarter- percentage point in December, compared with 55 percent odds a week ago."


Final Take: The Fed's Dilemma

The fact that the 10 year has risen to over 4% is a huge red flag! This is not good because its going to push mortgage rates higher. The reason the 10 year is moving higher is because the Treasury is handing out money like candy, and they need to raise cash in order to continue to do this.

The massive spending of cash by the Treasury comes at a price. The bond market then pushes the 10 year yields higher as a way to protect itself. We are at a 7 month high on the 10 year rate according to CNBC. It closed at around 4.00%.

This is BAD BAD BAD for housing because the 10 year bond rate is used to set many different mortgage rates. If the Fed continues to spend like a drunken sailor, then it risks spiking rates severely in the bond market.

This could DESTROY the housing market with higher mortgage rates. People can't afford to buy these homes at the current rates. Push rates to 8-9% and you will see a housing crash with virtually zero activity.

So what alternative does the Fed have?

The alternative is to start pulling liquidity from the system. They know that the financial system is in jeopardy if the 10 year rate continues to rise because housing will come to a come to a standstill. The banks are teetering on insolvency as it is and the Fed realizes a housing crash could be the final nail in the coffin.

So how does the Fed pull liquidity from the system?

The Fed can start pulling liquidity from the system by not touching interest rates or increasing them slightly and let equities take a tumble. They could even try to force a sell off. The reason they would do this is if equities drop, people will fly into treasuries out of fear which will then keep the treasury bond rates low due to high demand. This would then allow for the cheap lending to continue.

They could also pull liquidity out by changing what they accept at the discount window. I don't see this as a viable alternative because it would put too much pressure on the banks.

The one thing they know for sure is they cannot afford to let borrowing rates rise. The 10 year must not rise much above 4%. If the Fed has to stop spending spending and sacrifice the stock market in order to do it then that's the cost of doing business.

The risk of popping the debt bubble through higher borrowing rates is a bigger risk to them versus saving the financials through bailouts in the equity markets. The spending must stop now or we face a severe inflationary crisis with soaring interest rates.

The days of the Fed being a backstop to financials like Bear Stearns are over. They have spent $700 billion dollars and its forcing rates up in the bond market.

So the Fed faces a tough choice. Do you keep the liquidity flowing and risk inflation along with soaring interest rates to save equities, or do you pull liquidity out in order to keep borrowing rates low and protect the dollar and the debt bubble at the expense of the stock market?

Tough choice isn't it?