Where Are Interest Rates Headed?

On Thursday, the Wall Street Journal's John Hilsenrath reported that the Fed might be considering "sterilized" bond purchases as an alternative to more quantitative easing (QE). This report is especially notable since Hilsenrath is widely assumed to be a direct mouthpiece of the Fed. I can't say for sure whether this is true or not, but the belief that the Fed members used various Journal reporters to intentionally leak their intentions or thinking into the marketplace has been around as long as I've been trading bonds.

Anyway, "sterilized" monetary policy is where the central bank borrows money from one source and buys assets with the proceeds. In this respect, no new money is created in the system; the money has just been redistributed. The idea in the Journal piece is that the Fed might sell short-term repos, in effect, borrow the money from banks, and use those proceeds to buy long-term Treasury bonds or MBS. The thought is that this would allow the Fed do create somewhat more monetary accommodation but since it won't be printing money to do it, it would take less criticism from the anti-inflation crowd.

I don't find this argument very sensible, and if it had come from another source, I would have dismissed it. Taken at face value, it gives the inflation bugs way too much credit for understanding the finer points of monetary theory. I don't want to get too wonkish, but even those who do understand monetary theory well, such as Jim Grant, talk of things like malinvestment, which would be a problem under sterilized purchases anyway. However, if we assume Hilsenrath was leaked this information from the Fed itself, we have to take it a little more seriously.

Therefore, I'm thinking about the stories behind what is literally written on the page. It is possible that sterilized purchases are an acceptable compromise within the Federal Open Market Committee (FOMC) itself. So while the story is focused on external criticism of the Fed, the real impetus might be quelling internal debate while at the same time, allowing Bernanke to do something. While I do not believe sterilized purchases will have much impact on the economy, I do think that there is power in signaling. The Fed would essentially be telling the world, "Not only are we not accelerating a hiking cycle due to these better jobs numbers, we're actually trying to increase monetary accommodation!" That would make some difference. There also might be some desire to avoid the Fed becoming an element in the 2012 elections. So it puts out stories like this to downplay the impact of additional purchases.

I still think additional QE is more likely that these sterilized purchases, but it is something to watch closely. As I said, sterilized purchases will be much less impactful on the markets, but the effects could be more targeted. Whereas QE3 would tend to create more inflation expectations, sterilized purchases would act more like Operation Twist, because in that situation, the Fed was selling a shorter asset to buy a longer asset. The sterilized bond purchases are essentially the same thing.

The chart below shows the 10-30 slope, i.e., the rate differential between 10-year Treasuries and 30-year Treasuries around the period of Operation Twist. We see that after the pledge to keep rates low until 2013 was announced on August 9, the slope widened a bit, which is typical of increased inflation expectations increasing. But when the more targeted Twist program came around in September, the slope dropped about 30bps, reflecting the targeted nature of those purchases.

10-year Treasuries and 30-year Treasuries Differential

Source: Bloomberg Financial

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For my long-only portfolios, I'm underweight the 10-year and the longer part of the curve and very underweight the 20-year and longer part. So there is some underperformance risk for me should Operation Twist part deux come to fruition. But it is a risk I'm willing to take. However, if you are short the 20-plus part of the curve, for example, by using ProShares UltraShort Lehman 20+ TBT, you really need to think carefully about how this might impact you. A drop of 30 basis points in the 30-year note would be approximately 6 points in performance, or -12% on TBT.

In a related story, the 10-year Treasury note has risen to the top end of its recent range, and as I wrote two weeks ago, the range has been exceptionally tight in recent months. I expect support to hold on the 10-year at 2.06%, so doing some incremental buying makes sense right now. As I have said over and over again, it is hard to do anything other than take short-term tactical positions in longer-term bonds, but I'm moving out of a duration underweight.

At the time of publication, Graff was long various TIPS.