Fixed Income Recap

Treasuries
Treasuries marched lower throughout the day on poor participation in today’s $34 billion five year auction. The two-year finished the day down 1/64, and the ten-year was lower by 23/32. The benchmark curve was steeper by 3.8 basis points on the day and remains at +182 bps. A basis point represents .01%.

Treasuries opened lower this morning; feeling pressure from a failed forty-year U.K. government bond auction. By failed I simply mean there was a not enough demand for the entire amount the government wanted to sell. It was the first failed GILT (U.K. Treasury bonds) auction since 1995.

Today’s U.S. Treasury auction was described as poor, but in fact $70.4 billion of bids were submitted when the Treasury only wanted to sell $35.6 billion. Not too bad really!! $1.63 billion was bid at the U.K. auction; less than the $1.75 billion offered.

What is easing? Why is it damaging?
The Fed is running quite a complicated operation these days. Wait… the government issues debt and then buys it right back? How does that change anything?

In this process, referred to as Quantitative Easing, The Treasury issues debt to fund Government activities that aren’t already funded by tax revenue and the Fed goes into the open market and purchases the debt. This is sometimes looked at as a zero-sum transaction, but in fact it is far from it.

The Treasury, whose secretary is a member of the President’s cabinet, is fundamentally part of the government. The Federal Reserve, although created by an act of congress in 1913, is responsible for regulating the money supply and financial system as an independent institution. The degree of their actual independence is very crucial to their success or failure

The Fed can adjust short-term interest rates outright through its fed funds target rate in order to alter spending and saving behavior. If interest rates are high, people are rewarded more for saving, and borrowing becomes more costly so businesses slow down expansion. If interest rates are low people are paid less to save and businesses expand more because borrowing is cheap. Therefore, in general high interest rates lead to less spending and low interest rates lead to increased spending. We are currently in an environment where the Fed Funds rate is essentially zero (.15% as I write), but the economy is still contracting. If the goal is to continue to increase spending, but interest rates can’t be lowered any further, Quantitative Easing is the last resort.

The term “pumping money” is often used to illustrate the process of the Fed taking instruments of saving (Treasuries) out of circulation in exchange for money. The theory is that spending will increase because additional demand from the Fed will drive bond prices higher (yields lower) and increase the amount of money in circulation. “Printing money” is another term being used to illustrate the Fed actually creating money in order to pay for the securities. This may sound impossible but is one of the many negative attributes of fiat money.

How can this be a bad thing? If everyone simply had an extra $100 dollars in their pockets wouldn’t we just be better off? Not quite. In the same way that in the long run the government cannot spend what it does not take, either in taxes now or in the future, easy money policies must also be reversed.

It’s the reversal process that is damaging. Raising interest rates and taking money out of circulation causes spending to slow. If the Fed doesn’t operate independently enough there can be many political pressures to maintain an easy money policy for longer than an adequately independent Fed would prefer. In the end, the reversal is inevitable, and the longer the money supply is left to balloon, the greater the negative impact of this reversal will be.

From 2001 through the first half of 2004 we saw a Fed that was very loose for an extended period of time. As a result inflation manifested itself in the form of higher energy prices and a housing bubble that we are all very aware of by now. It may be easy to look back and see that the Fed was influenced too heavily by Washington, who pleaded for lower rates and easier credit policies to make the privilege of owning a home a Constitutional Right, but today’s policies aimed at correcting our current dilemma echo those of just years ago.

I believe the Fed is currently doing the right thing. My fear though is that Congressional and Presidential influence may keep the Fed from putting the brakes on at the appropriate time, resulting in a severe, and potentially damaging, inflationary environment.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst