DEFYING CRITICS , MARKET, FOMC TO STAY COURSE / BARRON´S MAGAZINE ( A MUST READ )

Up and Down Wall Street

FRIDAY, DECEMBER 10, 2010

Defying Critics, Market, FOMC to Stay Course

By RANDALL W. FORSYTH

Fed to continue to buy Treasuries even though it's not producing desired results.

In New York City, Off-Track Betting is closing up shop. OTB was the only bookie that ever managed to lose money, one of the denizens of its "parlors" observed to the New York Times. There's little doubt government would do any better in drugs, prostitution or loan-sharking. So if the public sector does such a lousy job running a vice operation, the continued opposition to a government takeover of health care is understandable.


Another government-run operation not doing too well these days is its manipulation of the government bond market, aka, QE2. In direct contradiction of the Federal Reserve's stated intent to lower the yields on Treasury notes, those interest rates have shot up since the central bank announced its intention to buy $600 billion of Uncle Sam's paper by mid-2011.


Given the contrary behavior of markets that the government tries to dominate, I would have preferred the Fed to announce a price-support program for gasoline. That way, prices at the pump surely would have plunged instead of rising about half a buck a gallon since the summer driving season ended.


The anomalous action of the Treasury market no doubt will be a provocative topic of conversation at Tuesday's meeting of the Federal Open Market Committee, the final get-together for the Fed's policy-setting panel for 2010. Fed watchers had expected this would be a fairly routine affair after the Nov. 2-3 meeting, when the FOMC hammered out and approved the plan for the $600 billion Treasury purchases. That decision seemed to have mapped out Fed policy at least through mid-2011.


Much has changed since then, however. The benchmark 10-year Treasury note yield increased nearly a full percentage point, from its low in early October to Thursday's intraday peak of 3.34%. Since late August, Fed Chairman Ben Bernanke and other officials were laying out the arguments for a second round of securities purchases to follow up the $1.7 trillion of mortgage, agency and Treasury buys starting in March 2009. Since the FOMC approved QE2 in early November, Treasury yields have moved steadily higher.


Mortgage interest rates have increased in tandem, with a conventional 30-year fixed-rate loan up to 4.61% in the latest Freddie Mac survey, up from a record low 4.17% less than a month ago. Sub-5% 30-year mortgages are getting more difficult to find in the past few days, which is deterring refinancings.


As often happens, a negative-feedback loop results from the Treasury market's impact on the mortgage market. As yields rise, mortgage bankers and investors in mortgage-backed securities hedge their positions by selling Treasuries, which puts upward pressure on note yields. That, in turn, pushes up mortgage rates, further exacerbating the effect. Sudden, sharp rises in rates, such as has been seen in the past couple of weeks, make this feedback effect even stronger.


If the Fed wants to dampen this rise, perhaps the FOMC could consider resuming purchases of mortgage-backed securities. Since August, the Fed has been replacing MBS paydowns with Treasury note purchases. It could simply replace the runoff of mortgages with new MBS purchases. That may have a more direct impact on the cost of home loans for Americans looking to buy homes or refinance. It is at least a topic worthy of discussion by the FOMC.


The withering criticism of QE2 from both abroad and in the U.S. surely will be a topic of conversation. If it is a part of the official proceeding of the FOMC, expect such terms as "clueless," as Germany's finance minister characterized Fed policy, to be redacted from the summary minutes of the meeting released in a few weeks.


What cannot be ignored is the nearly unprecedented torrent of criticism of Fed policy, which has been underscored by the bond market's contrary response of lifting yields in response to a policy that sought to do precisely the opposite.


Nevertheless, expect the FOMC to stay the course. Government policies don't change at the first sign of distress. It takes outright failure to switch courses. Just ask OTB.


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