It seems like every other day the last couple of weeks I read about how long Treasuries are tanking because markets are “worried about supply.” Then I read about how the Fed is saying they plan to buy long Treasuries, and they’re trying like heck to convince the markets that it’s really gonna happen, but the markets don’t quite believe it.
Maybe there’s a good reason that the markets don’t quite believe it: it doesn’t make any sense. The Treasury is going to issue a crapload of new long bonds, and the Fed is going to buy them back on the open market? Why? If the Treasury just issued short-term bills, the Fed would buy them anyway. At least it would buy enough to keep the federal funds rate near zero, and after that it doesn’t matter. And when the recession, or the potentially deflationary episode, or whatever it is, ends and the Fed wants to stop rolling over the bills, the Treasury can replace them with long bonds if it so chooses.
Now, you might say, “Ah, but when the recession, or the potentially deflationary episode, or whatever it is, ends, long term interest rates will go up, and the Treasury will have to pay more to borrow than it does now, so why not issue them now while the rates are cheap?” That reasoning seems to make sense, until you realize that the Fed, when this episode ends, is going to want to liquidate its long-term bond portfolio, and if rates have risen, it will have to do so at a loss. Since the Fed’s profits go directly into the Treasury, the loss passes right through, and, in terms of present value, it’s (almost) exactly as if the Treasury had issued new debt at a higher yield. Or the Fed could decide to hold the bonds to maturity, in which case it will be just as if the Treasury had never issued them. (In that case, if the Fed wants to reduce the money supply, it could stop rolling over its T-bills, in which case the Treasury will have to issue new ones at higher rates, just as it would have if it had not issued the long bonds in the first place.)
There are only two differences I can see between, on the one hand, having the Treasury issue long bonds and the Fed buy long bonds, and, on the other hand, having the Treasury never issue the bonds in the first place. And neither difference is really a difference. The first difference is that the Fed might buy seasoned bonds in addition to (or instead of) on-the-run issues. The Treasury, by definition, can only issue on-the-run bonds. But this, as I said, is not really a difference: the Treasury can just as well decide to retire its old bonds as to refrain from issuing new ones. Although most Treasury issues are not callable, the Treasury can retire them at market prices, and it will be just as if the Fed had bought them. And in any case, how much difference is there really between on-the-run and seasoned issues? The maturities are slightly different – no big deal in the grand scheme of things – and on-the-run issues are more liquid – a little bit more liquid, but it’s not like seasoned Treasuries sit on your books unintentionally for months because you can’t catch a bid. It’s a technical difference – one that will affect the details that Treasury traders care about, but not the sort of thing that should make headlines.
The other difference is between current policy and future policy. If future policymakers will be somehow influenced by the distribution of securities between the Treasury and the Fed, then that distribution will of course make a difference. But why should they be influenced by it? I can understand that the Fed and the Treasury may perceive themselves as having different interests, but in this case it doesn’t matter, because each one can undo what the other one does. If the Fed sells off its long bonds 5 years from now, the Treasury can stop issuing long bonds. If the Fed holds onto its long bonds, the Treasury can issue more of them. And if the Fed never buys the long bonds in the first place, then the Treasury can do whatever it wants with its finance policy 5 years from now. Again, there are the technical questions about maturity and liquidity, but I don’t see how these are going to make a difference that macro policy makers or investors (as opposed to traders) should care about. And since the timing of these events is unknown, I’m not even sure anyone would be able to make a reasonable guess as to how these technical matters will play out, so perhaps noone at all should care about them.
So what’s going on here? I really don’t get it. Are the Treasury and the Fed really going to insist on working against each other? Is one of them bluffing? (And if so, which one?) Have the markets misinterpreted their signals? Have the markets, in fact, correctly interpreted their signals as being meaningless?
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.
Memories of Con Jobs Past
51 minutes ago