Rising Treasury yields

By John Authers, Investment Editor - Financial Times
Published: May 27 2009

There is an old market adage that you should not fight the Fed. The Federal Reserve has more bullets than anyone else.

However, maybe the Fed itself needs an adage not to fight the bond market. The yields paid on US treasuries provide the “risk-free” rates that undergird the world’s financial system. They are set by a ruthless and highly liquid market.

The US masterplan for revival is clear: cut interest rates and buy mortgage-backed bonds and treasuries in enough volume to force down their yields. This makes houses more affordable, so their prices go up, and the banks’ final losses from toxic mortgage bonds will be less.

The problem is the Fed must buy a lot of bonds to achieve this and the Treasury market is disposed to pick a fight.

After Wednesday’s auction of five-year bonds, yields soared. Mortgage rates, which had kept low thanks to tighter spreads over treasuries, capitulated.

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).

The 10-year Treasury yield rose from 3.55 to 3.74 per cent; when the Fed unveiled its plans to buy bonds, it was 2.08 per cent.

Tellingly, the bond uproar turned a quiet day on the stock market into a very bad one. The S&P 500 fell 1.9 per cent.

The spread of 10-year over 2-year yields hit a new high of 2.78 percentage points. This lets banks make easy profits from short-term borrowing (from depositors) and longer-term lending. But it will not redress the damage higher rates could do to the toxic assets on their balance sheets.

Stocks are making a habit of turning south after midday bond auctions. That is a gauge of their profound importance.