On Wednesday, January 25, the U.S. Federal Reserve said it would keep interest rates at their current exceptionally low level until the end of 2014. Forget about the middle of 2013, which seemed extremely far away when the Fed made that “guarantee” in August. And forget about the beginning or middle of 2014. Now the Fed is talking about the end of 2014.

Almost three years from now. Three years with short-term interest rates near 0%.

Let’s cut straight to the chase for investors: Who wins and who loses from this extraordinary statement of policy by the U.S. central bank? Read more

Fear continues to climb.

You can see it, of course, in the stock markets where the Dow Jones Industrial Average is down 2.72% as of 11:56 New York time and the Standard & Poor’s 500 stock index is down 3.09%. Things are even worse in this morning in Europe, the driver for today’s extreme fear, where the French CAC index is down 4.02%, the German DAX index 3.52%, and the Spanish Ibex 3.89%.

But for real evidence of the extent of the fear look to the Treasury market where investors are flocking to U.S. debt—and we all know how safe that is in the long run. Buying has dropped the yield on the 2-year note to a record low of 0.2803%. The 10-year bond yields less than 2.5% for the first time since November 2010. Go out 30-years and the long bond is paying 3.743%. That’s a drop in yield from 3.90% yesterday.

The level of fear is drowning out anything vaguely positive and we have had two mildly positive bits of news this morning. Read more

Bond market yawns at U.S. default and buys $35 billion in 5-year Treasuries at today’s auction

Still no buyers strike or even a whiff of panic in the market for U.S. Treasuries. Although global stock markets sure are getting anxious.

Today’s auction of $35 billion in five-year notes doesn’t rate as a rip-roaring vote of confidence as Congress fiddles with raising the U.S. debt ceiling. But the Treasury Department sold these notes with a yield of 1.58%. That was a small increase from the 1.562% yield in the market just before the auction.

The bid to cover ratio, a measure of how many bids there were for each dollar of bond offered in the auction, was 2.62. (There were $2.62 in bids for every $1 in the auction, in other words.) That was higher than the 2.59 of a month ago, but below the average of 2.84 in the four previous auctions of five-year notes.

Indirect bids, a pretty good proxy for buying by foreign central banks and other overseas investors fell to 36.6% from a recent average of 41.8%.

The five-year Treasury note closed for the day at a yield of 1.52%

What comes after QE2?

Who will pick up the slack after the Federal Reserve ends its second program of quantitative easing at the end of June and stops buying $75 billion in U.S. Treasuries every month? Not exactly a minor question for a country running a national debt of $14.5 trillion.

The answer, investors fear, is No one. That would lead to an increase in U.S. interests rates—if the market found buyers at all, they would ask for a higher yield—just at time when the U.S. economy is slowing. The worst case scenario would be that some delay in raising the U.S. debt ceiling would create a technical U.S. default just at the same time as the Fed exits the Treasury market. That could lead to a spike in U.S. interest rates rather than a more gradual increase. Which would doom any chance for a recovery in the housing market and lead to massive losses for anyone holding a portfolio of Treasuries.

At least that’s how the worry goes.

I’ve been racking my brain to find another answer. I think QE3 is off the table. The Federal Reserve isn’t about to take on the financial and political risk of adding another half trillion or so to a balance sheet that has climbed to $2.84 trillion as a result of the central bank’s battle against the effects of the global financial crisis.

But recent decisions by the regulators drawing up the new Basel III rules for the global banking system point me to a real alternative to the disaster scenario I think markets fear for the Treasury market.

Basel III will ride to the rescue.

Basel III? Yep, Basel III, the bank regulation scheme more complicated that Ptolemy’s astronomy and much less likely to work as predicted. I don’t know that I’d call Basel III a rescue plan for the developed world’s central banks—the Federal Reserve, the Bank of Japan, the Bank of England, and the European Central Bank—because I don’t know if the regulators (including central bankers) who put together the rules intended to rescue central banks. The rescue may just be an unintended consequence of the new banking regulations.

But intended or not, plan or side effect, Basel III does promise to “solve” central bank’s big balance sheet problems—for a few years anyway.

Let me show you how this is likely to work and then run through some of the dangers that this “solution” creates. Read more

The Federal Reserve released its inner musings from its April 26-27 meeting yesterday, May 18.

No surprises in these minutes.

Ben Bernanke’s Fed continues to worry about the strength of the recovery in the U.S. economy, and would prefer to do nothing to unwind its balance sheet until it sees signs that the recovery is more solid than it looks right now.

Members spent as much time discussing how to communicate any eventual sale of its holdings and the first increase in short-term rates as they did debating the timing of those moves.

As Bernanke has said repeatedly recently, the first move to reduce the Fed’s huge balance sheet—totally some $2.7 trillion as a result of buying mortgage-backed securities and Treasuries as part of its two programs of quantitative easing—will be allowing some of the Fed’s $900 billion in mortgage-backed securities to mature without reinvesting the cash in new Treasuries. (Right now the Fed is reinvesting the proceeds in new debt instruments as holdings mature.) That would begin to shrink the Feds balance sheet.

The second move would be a decision to let the Fed’s $1.5 billion in Treasuries mature without reinvesting the proceeds. Read more