(06/10/09) Fed May Raise Rates Sooner Than Expected: The Effect on Currenc

US ten-year bond yields hit a seven-month high on Monday. The USD rallied, supported by rising bond yields and speculation that the Fed may have to raise interest rates sooner than expected to combat inflation fears. Bond yields are rising for three reasons: increased government supply to finance the rising US budget deficit, concern that the expanding Fed balance sheet will fuel inflation, and signs that the worst for the US economy has passed. The Obama administration estimates that the 2009 budget deficit will hit $1.8 trillion. The US government is expected to issue more than $2 trillion in debt during fiscal 2009. Investors are demanding higher yields to buy US debt because of the increased supply of bonds. In his testimony last week before Congress, Fed chairman Bernanke said that US GDP/debt ratio could rise from 40% of GDP to 70% of GDP by 2011. Many analysts argue that US deficit spending at this rate of GDP is unsustainable.

At the same time, the US government is issuing new debt and the Treasury is selling the debt the Fed is buying as US bonds. The Fed plans to buy $300 billion in Treasury bonds and $1.25 trillion in mortgage debt to support the housing market and economy. The Fed’s balance sheet has expanded as reserves have ballooned to $900 billion, up from $11 billion before the asset purchase plan was implemented. The expansion of the Fed's balance sheet could fuel inflation. US bond yields are rising as the Fed tries to push them lower. The function of the market is to discipline government.

Fed officials suggest the yield rise reflects diminished safe-haven demand for US bonds as the economy stabilizes and investors seek higher yields in riskier investments. The Fed's Dudley says that the recent rise in US bond yields reflects more confidence in the economic outlook. Friday's release of a smaller rise in US NFP fuels speculation that the worst for the US economy has passed. Fed officials are discussing possible exit strategies from quantitative easing and hope these discussions will help cool bond market volatility and stem the rise of bond yields. The two main exit strategies being discussed are the sale of reserves through reverse repos or the issuance of 30-day Fed T-bills, which would help spread the Fed's liabilities and manage its balance sheet. Either way, when the Fed starts its exit strategy, interest rates will likely be higher. According to the Fed futures on the CME, there is a 58% chance that the Fed will raise rates by at least 50 basis points at the November 2009 policy meeting. Rising interest rates may choke the US and global recovery. It is far from clear whether improving US economic news is sustainable and can withstand rising yields. Monday, President Obama said that the US remains in a deep recession, that it will take considerable time to recover, but added that moderating job losses is encouraging. Tuesday, the USD traded lower as investors reassessed the likelihood that the Fed would raise interest rates at the end of 2009. According to a Bloomberg report, speculators who expect US interest rates to head higher this year are wrong. The report surveyed 15 of the 16 primary dealers that deal directly with the Fed and the majority predict no US rate increase until at least the second half of 2010. The job market, housing market, and financial markets must show considerable improvement before the Fed hikes rates. High unemployment and weak housing markets will likely stop the Fed from raising rates before 2010.

The recent debate about replacing the USD as the global reserve currency is an additional threat to the funding of US deficit, which could lead to higher yields and a weaker USD. Last week, the President of Russia called for establishment of an alternative to the USD. The governor of the Bank of China recently called for the creation of the super sovereign reserve currency and the Chinese PM has expressed concern that the weaker USD will hurt China's US investments. The World Bank president Zoellick says that China may diversify reserves away from the USD. Monday, the head of China's second largest bank said that the US should start issuing bonds in Yuan and the IMF said that there is a strong possibility of the development of a new reserve currency to replace the USD. This suggests the USD rally is a correction, not a bottom, and the USD Fed rate hike speculation rally is a selling opportunity.

Note in the daily ten-year note graph below the sharp drop in prices and rise in bond yields since November. The ten-year note is approaching major support around last year’s lows near 11,200. A break of this level could send yields above 4% and increase the risk of a double dip recession.