Will the Fed keep short-term interest rates near zero for a long time?

This week represents a critical juncture for long-term interest rates and a significant move should be coming soon. Our line in the sand for the 10 year Treasury remains at 3.58% with today’s rate at 3.49% BUT the inflation component has soared to 2.25% an increase of 23 basis points in the past two weeks. Are inflationary expectations really rising? Everyone is aware of the massive expansion of the money supply by the Fed and the fact they are no longer buying Treasury securities. This information has been in the market for months and rates haven’t moved out of a tight trading range centered around 3.50%. Gold has rallied six consecutive days to a new high of $1100+ but that is more of a move away from paper currencies than a fear of inflation.

Tuesday’s 3 year Treasury auction went as expected but short end paper almost always is gobbled up by foreign central banks. The real test for long rates will come on Thursday when $16 billion 30 year bonds end the week’s bidding for Treasuries. Dealers appear to be well hedged as open interest in the futures has increased sharply in the past few days and put buying swamps call buying each day as everyone seems to have made the “sure bet” on rising interest rates. If we break 3.58% those with existing short positions will press their bets sending rates to the 3.75% level but if we don’t break 3.58% many of these same shorts who didn’t cover in the auctions may create a “squeeze” sending rates quickly to 3.30%.

Tueday’s 2%+ stock advance caused by money managers caught with too much cash and too little performance AND another dollar bashing (except the yen) should have given rates a clear path higher but bonds held well all day. If stocks correct from last week’s advance it might set up a flight back to safety sending rates lower. The longer we hold below 3.58% the better chance to head for 3.30% or lower depending on the size of those betting on higher rates.

We should know the answer to the rate question soon and hopefully the seasonal trend to lower rates will appear again this year. (75% occurrences since 1966)

Has anyone besides the Fed been buying Treasuries?

Although everyone is worried about increasing supply of Treasury debt and no one to buy it except dealers that must participate in every auction there have been two other major buyers this year. A Bloomberg article reports Japan bought $105 billion of US Treasury debt through the first eight months of this year increasing its holdings to $731 billion. China purchased $69.7 billion and raised its holdings to $797 billion. Why would these countries buy US debt knowing rates are headed higher accompanied by a depreciating dollar? Since we only see the future from our own past experiences and Japan has suffered from debilitating deflation for almost 20 years their investors expect a repeat in the US leading to much lower interest rates. The 10 year Japanese government bond is currently trading at 1.48% and if the US came close to that level it would create big profits for buyers of the 10 year note. In terms of the dollar Japanese investors have seen a rising yen despite a weak economy and if the US economy repeats the Japanese experience the dollar could soar. It’s not a bet I would make but Japanese investors see the world much differently than those in the US because they have lived the deflation experience and don’t know anything different.

The Chinese have a different strategy and reasoning for purchases of US Treasury notes. The Chinese have almost $2 trillion of foreign currency reserves and are finding it difficult to diversify into other assets with out moving markets due to their size. The Chinese Yuan’s value is tied directly to the dollar and although the Chinese would like to move assets out of dollars they can’t for fear the dollar will depreciate “too much” thus placing the Chinese in a position where they would have to allow the yuan to float up taking away some of their competitive edge in world markets. This is one of the reasons the Chinese are buying gold and other assets to hedge dollar exposure. They can use some of their reserves to make bets on commodities that rise when the dollar falls. With the left hand they are doing the politically correct thing and buying Treasuries and with the right hand are doing their best to hedge off their massive dollar exposure. It’s not easy but when you have the most reserves of any nation you can afford to try many different strategies.

Fed loan survey reveals a few gold nuggets

The Fed’s quarterly senior loan officer survey was released on Monday  and although the results show a slight loosening of underwriting standards the three special questions asked this quarter revealed valuable information that can help in our quest to determine the future course of interest rates. The first question asked bankers about the reasons for the sharp decline in commercial and industrial loans this year. The two main reasons given were a decrease in originations of term loans (banks don’t want to loan against collateral that may not hold its value) and corporations drawing down less on revolving credit lines. The latter is important because it shows corporations are trying to self fund their need for $$$ AND very few are expanding which is the main reason corporations borrow or draw down lines of credit.

The 2nd question asked bankers about the status of commercial real estate loans in their portfolios. The almost unanimous answer was that loans that were due to mature this year have been extended more than refinanced as the “pretend and extend” strategy extends across the country. The Fed will need to keep short term rates at 0.0% for a very long time to enable banks to earn enough to offset the “real” losses banks have on these under water commercial real estate loans.

The last question was about potential changes in bank credit card lending due to the implementation of the recently passed credit card bill. This brought the most interesting answer of the survey because banks reported they had NOT yet complied with the new law but when they did it would lead to tightening of terms and conditions on credit card loans. Consumers are being forced to increase savings and cut spending due to recent cuts in credit card limits and the new legislation is going to make a bad situation worse for consumers as again we see unintended consequences from government intervention.