Oxstones Investment Club™by Tom Lauricella and Mark Gongloff, WSJ
The Federal Reserve on Wednesday set the stage for falling yields on bonds of just about every stripe, providing fuel for a weaker dollar and higher stock and commodities prices.
The Fed’s plan to pump another $600 billion into the financial markets by buying U.S. Treasury bonds, while long anticipated by financial markets, succeeded in nudging the Dow Jones Industrial Average to close at a two-year high of 11215.13. Prices on some government bonds rose after the announcement, while 30-year Treasurys dropped on disappointment the Fed won’t be as active a buyer in that part of the market.
While the response was relatively muted on Wednesday, analysts and investors anticipate the Fed’s buying will play out in financial markets globally for months to come.
“This is going to be the major theme for the next year,” said John Briggs, U.S. Treasury market strategist at RBS Global Banking and Markets. “It gets people out of safe Treasurys and into other assets.”
In an effort to strengthen the economy and boost inflation, the Fed said it will purchase roughly $75 billion a month in U.S. Treasury securities from investors through the end of June 2011. While the total expected purchases of $600 billion was somewhat higher than many investors had expected, the pace of the buying was spread out more thinly than anticipated.
Stock gyrated after the announcement and in the end, the Dow Jones Industrial Average eked out a 26.41-point gain, or 0.24%, but that was enough to close at its highest level since September 2008. The next milestone for the Dow is 11421.99, the level it held before Lehman Brothers collapsed in 2008.
The real surprise of the day came in the details of which Treasury bonds the Fed plans on buying. In its first round of quantitative easing in 2009, the Fed concentrated most of its Treasury-purchases program in two- to 10-year maturities. But some in the bond market had wagered that the Fed would increase its purchases of longer-dated Treasurys, expectations that were fueled by a Goldman Sachs note Monday predicting such a change.
Instead, the New York Fed said that just 4% of its purchases would be in the 17-to-30-year-maturity range, down from 6% in the previous program, according to an estimate by David Ader, chief government-bond strategist at CRT Capital. The Fed also trimmed its purchases in the 10-to-17-year-maturity range to 2% from 8%, Mr. Ader noted.
The 30-year bond tumbled nearly 4% in price in little more than an hour after the Fed’s announcement. The yield, which rises as prices fall, rose to above 4.06%, the highest in three months.
The 10-year Treasury note also fell in price shortly after the Fed announcement, pushing its yield higher. But it recovered in late trading, sending its yield below 2.6%, the lowest in more than a week. The 10-year Treasury yield is important because it influences other borrowing costs in the economy, including 30-year mortgage rates.
If the Fed succeeds in raising inflation expectations, the 30-year bond might persistently lag shorter-dated bonds, keeping its yield higher.
But given the Fed’s apparent commitment to low interest rates and nagging weakness in the economy, many think that the selloff will prove short-lived, given the Fed’s commitment to juicing the economy.
“The long-bond yield has retraced all its QE-related gains as if the Fed’s not going to buy anything,” Jim Vogel, analyst at FTN Financial, wrote in an email.
The Fed’s announcement cemented expectations that it won’t raise interest rates any time soon. In the futures market, where traders bet on future Fed policy, expectations are that the first Fed rate increase won’t come until June 2012.
It also came on the heels of midterm congressional elections that also played out largely as traders had been expecting, with Republicans taking control of the House of Representatives but Democrats holding control of the Senate.
At RBS, Mr. Briggs noted that the Fed’s $600 billion in expected purchases, on top of an expected $250 billion to $300 billion reinvested from maturing existing bond holdings, will absorb a large percentage of expected net new bond issuance in 2011. RBS estimates that in 2011, the net new issuance of “high quality” bonds issued by the U.S. Treasury, government agencies and corporations, will total $1.352 trillion.
With the Fed potentially buying $900 billion of that, “it leaves very little for the rest of us,” Mr. Briggs said. That scenario would result in downward pressure on yields across nearly the entire bond market, he added.
In turn, that could provide a tail wind for the U.S. stock market, said Erin Browne a macro stock-market strategist at Citigroup. From her vantage point, Ms. Browne said it appears that many hedge funds haven’t participated in the recent rally in stocks, which has seen the Dow rise 12.3% since late August. “Given that stocks are under-owned and valuations are cheap, equities are going to be fast to respond” as the Fed actual starts its bond market purchases, she said.
In the currency market, many said the lack of a meaningful move to the Fed’s announcement shouldn’t be interpreted as meaning the dollar won’t feel an effect. On Wednesday the euro gained 0.66% against the dollar to $1.4121 but the dollar rose against the yen.
The dynamics of the Fed keeping interest rates low and pushing investors to higher-yielding investments outside the U.S., such as emerging markets, “means the dollar will see a persistent weakness going forward,” said Aroop Chatterjee, currency strategist at Barclays Capital.
Write to Tom Lauricella at tom.lauricella@wsj.com and Mark Gongloff at mark.gongloff@wsj.com
Tags: declining yields, low interest rates, monetary policy, Printing Money, Quant Easing, The Fed