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

Let me set you a riddle.

How is the recent crash in the price of silver like the crash in the mortgage market that almost took down the global financial system?

The two are of very different dimensions, certainly. The silver crash simply took silver from near $50 an ounce to $35 and set off a one-week selloff in the price of other commodities that roiled the U.S. stock market. The mortgage crisis took down Bear Stearns and Lehman Brothers—and almost got American International Group and Citigroup. It took massive intervention by the Federal Reserve and the world’s other central banks to keep financial markets operating at all and we’re all still paying the price of the Great Recession that followed.

But they have a curious and important similarity. Both involve an attempt to hedge away risk—that itself actually created exactly the kind of explosive financial downdraft that the hedging was intended to make impossible or at least unlikely.

The lesson here is that the flight to safety carried to enough of an extreme by enough investors can turn into its own financial bubble. Safety carried to excess is the exact antithesis of safety.

Let me explain what I mean and then suggest what this tells us about the future of the financial markets. Read more

Financial markets punish dollar and not Treasuries–so far

So why is it that U.S. bond prices aren’t sinking and why is it that U.S. bond yields aren’t sinking?

Can’t be that overseas investors found last week’s near shutdown of the U.S. government a reassuring sign of Washington’s fiscal responsibility.

Yields on U.S. bonds are lower now than when the government was running a budget surplus a decade ago—and when the amount of U.S. government debt outstanding was much, much lower. Marketable debt outstanding has climbed to $9.13 trillion from $4.34 trillion in the middle of 2007.

But the yield on the benchmark 10-year Treasury is just 3.49% as I post this on April 12. The average yield from 1998 through 2001, according to Bloomberg, was 5.48%.

And overseas investors aren’t fleeing the U.S. Treasury market. Foreign central banks bought 60% of the $66 billion in 10-year notes sold this year, up from 42% in 2010, according to the U.S. Treasury. Foreign investors as a whole owned $4.45 trillion in Treasuries as of January 2011, up from $3.7 trillion in January 2010.

The market certainly doesn’t seem to be worried about the chances of a U.S. default. Credit-default swaps on U.S. Treasuries—a kind of insurance against a bond issuer defaulting—stand at 0.415 percentage points. That’s a drop from the 2011 high of 0.515 on January 27.

I can think of two explanations for this—and, no, neither of them depends on overseas investors thinking U.S. politicians are any better at economics than they actually are. Read more

Nothing surprising in the news from the Federal Reserve’s Open Market Committee yesterday. The Fed said its plans were unchanged and that it would buy $600 billion in Treasuries in the first six months of 2011 in order to stimulate the economy. The economy itself, the central bank said, was doing better but not better enough to cut unemployment or to change the Fed’s program of bond buying

Nothing new but Treasury prices still took it hard. Prices on the 10-year Treasury fell and the yield climbed to 3.4% as of 2:37 New York time. Prices on the 30-year bond fell and the yield rose to 4.51%.

Bond prices weren’t helped by a bigger than expected gain in retail sales in November of 0.8% also announced yesterday. Economists surveyed by Bloomberg had been looking for a gain of 0.6%. The Department of Commerce also revised October’s increase in retail sales up to 1.7%. If the economy is accelerating, bond investors would want higher yields to compensate for a greater risk of inflation.

On the technical charts Treasury bonds and notes have entered territory that usually leads to further declines in bond prices. Read more