The Treasury trap

These are interesting times.

One of the biggest stories of yesterday was the Treasuries and I thought, although delayed, it shouldn’t be missed.  It was quite sudden that yields on shorter-term securities spiked as fear of inflation became the news again.  The 10-year note hit its highest since November of last year with 3.695%, and an intraday high of 3.732%, significantly up from 3.491% on Tuesday night.  This increase can be looked at in two ways: (from WSJ)

It suggests that investors believe prices will rise, and they are willing to sell out of ultrasafe Treasury bonds and buy riskier debt. A steeper yield curve is also good for banks, because it allows them to borrow in the short term at lower interest rates and lend at higher rates for longer periods.

But rising yields also make the government’s rescue efforts more expensive. The government could have to borrow more to finance bailouts, and the Fed itself could lose money on the mortgage-backed securities and Treasurys it has already bought.

Another story is the widened gap between its yield and that of the 2-year note, or the yield curve, which hit a record of 2.75 percent.

One fear that came out of this was the possible increase in mortgage rates that threaten to cut the effects of the government’s efforts to make housing more accessible to others.  Furthermore, this also renders securities backed by mortgages less attractive as they fear upcoming rise in rates, therefore, paying more interest.

From the FT:

By the end of New York trading, the 30-year Fannie Mae mortgage rate had leapt from 4.23 to 4.7 per cent, its highest since December and more than a percentage point above its low. A brief boom in mortgage refinancing was already tapering off, so this is bad news for the Fed (and many others).

After the Fed has pledged to buy long-term Treasuries a couple of months back, the officials didn’t rule out the possibility of increasing that purchase if need be so, a statement put on record through the latest FOMC minutes.  It seems that the Fed might just head that way in order to control the splurge in interest rates. Experts believe the next key level is going to be 3.75%.

Now it seems that the Fed is in a trap.  While it does want to see the rates maintained low, particularly mortage-backed securities, it might prove to be challenge.

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