Fed's Rate Quandary: Buy In More Bonds, or Let The Market Have Its Way?

One of the Federal Reserve's measures toward recovery is the purchase of long Treasury bonds, as well as mortgage-related securities, to keep a lid on long-term interest rates, to give a housing recovery time to take root. But despite of the Fed's efforts interest rates are rising, and the end of The Bank's authorization is in sight. And the latest reports from Treasury suggest that the hungriest buyer of the last few years, China, may be losing its appetite.

The price of 30-year fixed-rate mortgages has climbed from under five percent in April to 5.67 percent on June 15, threatening hopes for a housing recovery. (For timely coverage on the topic, visit the posts of my astute MoneyWatch colleagues Charles Wallace and Ilyce Glink.)

And in fact, the housing recovery may be faltering: the confidence index of the National Association of Home Builders, reported on June 15, slipped to 15, from 16 in May, although it remains above its floor of 8 in January. An index of buyer traffic registered an anemic 13 for May.

Back to interest rates. It's not that the Fed hasn't been trying to keep them low: from an out-of-the-ordinary authorization in March to buy up to $300 billion of long-term Treasury bonds, as well as $1.25 trillion in mortgage-backed securities (MBS) -- meant to drive prices up, and yields down -- the Federal Reserve had purchased $125 billion of Treasuries and $428 billion of MBS as of May 27. (The Fed typically conducts its policy with short-term instruments.)

But the bond market tells us these efforts aren't enough. Yields on Treasury securities have risen sharply in several months, although from artificially low, flight-to-quality induced levels. Bouncing off a 2.5 percent floor in mid December, the 30-year passed through 3 percent in late January, and 4 percent in late April (the green line in the graph below). Last Thursday, a good-sized auction of 30-year Treasuries, $11 billion worth, was priced at 4.72 percent.

And Fed officials are doubting the mission too, reports Bloomberg:

The Federal Reserve isn't capable of offsetting the "flood" of U.S. Treasury borrowing with its bond-purchase program, which has aided a revival of credit markets, Dallas district-bank President Richard Fisher said.

"The program has had its impact," Fisher said today in an interview with Bloomberg Television. "At the same time, you cannot counter this enormous flood" of borrowing "coming from the United States Treasury."

The numbers in the TIC reports swing around a lot, and they are a month out of date, but the bottom line says international investors bought $11.2 billion of long-term U.S. securities in April, down from February ($22.0 billion) and March ($55.4), but up from a net outflow of $37 billion in January.

"This is a very weak report," notes Brad Setser at The Council on Foreign Relations' Follow The Money. Counting short-term flows, the net-net was negative, and the rise in China's holdings, which he carefully tracks, was modest. Setser's conclusion:

China's overall portfolio isn't rising at anywhere like the pace it did in 2006, 2007 or 2008.

Dr. Setser's views notwithstanding, the report of last week's 30-year auction showed heavy foreign participation. And in trading today, 30-year yields were down 5 basis points to 4.59 percent, from 4.72 percent at last week's auction, and that was after the issue of the TIC information. Later this week, Tuesday and Wednesday, the Fed will be in the market to buy more bonds, three-to-four year and seven-to-10 year maturities respectively.

And the Financial Times today reported that Fed officials are considering redirecting some of the capital authorized for mortgage-backed bonds into Treasuries.

So maybe the Fed purchases are helping a little. But after just a few months, there's not much of the authorized funds left.

Financial disclosure: The writer owns shares of an ETF that returns twice the inverse of the return on the 20-year U.S. Treasury bond.