Fed Buying Bodes Ill for Bonds

03/08/2010 11:10 am EST

Focus: MARKETS

Curtis Hesler

Editor, Professional Timing Service

Curtis Hesler, editor of Professional Timing Service, says the central bank has to hold interest rates down for current policy to succeed, but that can't last.

The bond market has come back to life recently. Bonds may even get back to a positive stance in [our] Rydex bond trading program.

I do want to point out, however, that the model is beginning to whipsaw. For traders, whipsaws are something that have to be put up with. For the non-trader, whipsaws are an important omen: They tend to cluster at significant turning points.

The [Federal Reserve] hiked the discount rate last month from 0.50% to 0.75%. This is not as much a painful move as a message. The Fed wants member banks to reduce their borrowing from the Fed. It is not a real tightening, of course, but perhaps it provides an inkling into the future.

The Fed is in a tough spot. They have been buying mortgages from the banks, usually in the form of mortgage-backed bonds. The banks take the money and buy Treasuries. The result is symbiotic. The banks get rid of what they don’t want, and the Fed gets something they do want—Treasury buyers. The Fed’s intent is to sell the mortgage-backed bonds back into the market once the recovery begins and things return to normal. Raising rates will kill the plan.

The Fed has many tools in its kit bag. One tool that has been used more often than not over the last few years is “gentle persuasion.” Bank regulators can be lenient, strict, or something in between. Raising the discount rate is a message only.

The problem, however, remains twofold. One, the government will continue to need buyers at the Treasury auctions, and buyers have been more difficult to find since 2008. Two, the banks have to “appear” solvent and in good shape because confidence is what the entire financial game, including the value of our currency, is based on.

I can see the big kids maneuvering to bolster the market for our public debt; but by year’s end, I look for some dislocations. The epicenter may be tied to real estate. I can see no way that the government can continue to finance the current levels of public debt. They desperately need lenders.

When there is more illusion than solid reality in the financial environment, one should take pause. The bond market will wiggle and jiggle under these ongoing influences; but fundamentally, it is not a good place for long-term investment money.

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