Since the global financial crisis erupted in full last year, most attention was given to short term interest rates. Central Banks were seemingly engaged in a race to zero, trying to bring their respective benchmarks to the lowest possible levels. This was meant to prevent a freeze in credit markets and encourage banks to write loans. Once most Central Banks managed to increase money supply, general focus shifted to stock markets, which were hitting multi year lows. Now that equities world wide staged impressive rallies, attention once again has moved to interest rates. Long term this time.

These rates are not set by Treasuries, by rather determined by the market. In earlier phases of the crisis, with uncertain investors seeking safety, the demand for long term Treasuries, both notes and bonds, pushed them to an all time high while dramatically suppressing rates. Unfortunately, these are also the instruments through which government is financing fantastic budget hole. Treasury will have to float trillions in new debt in the next two or three years alone. Combined with signs of recovery world wide, increased supply of Treasuries is sparking new fears of inflation, pushing rates higher.

This is an unwelcome development to FED, as mortgage rates are directly influenced by rates on 10 year Treasury Notes. The cornerstone of FED’s involvement, since this whole mess started, has been keeping mortgage rates low. Many analysts seem this strategy as ill conceived. With rising unemployment, less and less people will qualify for loans from the banks, no matter how low the rates are. Regardless, FED stayed the course. After effectively reducing short term rates to 0%, central bank moved to direct purchases of such financial assets as mortgage backed securities. When this was not enough, FED started to accumulate long term Treasuries for the first time in half century. In spite of this titanic effort, rates continued to climb all of May.

Data from http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml

We see sudden drop in rates on Friday, May 29th, on renewed buying by FED, which is believed to accumulate at least $500 Billion in securities to date. Continued purchases are all but inevitable. Biggest problem with this approach is the simple fact that FED’s actions do not retire the debt, but rather store it. These notes and bonds will have to be returned to open market putting additional strained on the rates. There are limits to how much central bank can do, and those limitations are probably within reach.

Long term Treasuries have been falling in price since the beginning of 2009. Initial sell off was nothing more than a normal market response, following the “flight to safety” buying in late 2008. As global situation normalized, money was distributed more widely. Nothing worrisome about that. Last few weeks, however, were another story. Price of 30 year bonds fell sharply to 116.00 before jumping on FED buying last Friday. With this market clearly being  the current focal point, central bank will try to reassure jittery participants once more by renewed intervention, an action which could push the price to 123-125 area over next few weeks, before down trend resumes.

What does it mean to a dollar? In normal environment, when the global economy, the financial system is stable and major economies are growing, higher rates would be strengthening underlying currency. The dollar would benefit from such an aggressive move in interest rates, on a premise that investors seeking higher yields buy the Treasuries and the U.S. dollar. Under typical scenario increased rates could be associated with financial authorities who are trying to cool off inflationary pressures from an expanding economy. We saw it first hand in currencies like AUD, NZD and others in years preceding current crisis.

These are not normal times, and markets are not following path that most of us consider typical. This time around interest rates are rising on threats, real or perceived, of inflation. Future inflation, at that, signs of which are not visible yet. Regardless of reasoning, dollar has been linked to performance of Treasuries, falling with them over last few weeks.

Chart of EUR-USD is a very good proxy for the Dollar, being the biggest and most liquid of USD pairs. We can see it has been “hugging” the Treasuries for last couple of months (inverted). It is likely to do so for most immediate future, as sketched out above. But what is next? This increasing gap between short term and long term interest rates is not likely to last very long. Something will have to give.

One possible development is that short term interest rates will start to follow long term ones. Even if that was to happen, it would take considerable time before they are attractive enough in relation to AUD and NZD. Short term rates are set by FOMC and so far FED has not shown any interest in bumping them up. As a matter of fact, judging by central bank’s official statements, they intend to keep them low as long as possible, maybe for years. With this in mind, the Dollar is unlikely to get a boost from official monetary policies.

Another potential scenario is that long term rates will continue to increase over time. This would put increased pressure on a still fragile domestic and global economy as well as elevated expectations on financial authorities. Moreover, a continued deterioration in the U.S. credit market slows down any recovery here. This is not good for export-driven global economies and the international financial system. This could possibly cause another collapse of world stock markets with one more ”flight to safety” syndrome. If this happens, Dollar will once again become an asset of choice for few months or a year.

It appears that financial markets are at cross roads marked by long term Treasuries. Their behavior will greatly influence next major moves in stock markets and currencies. Possibly commodities as well. One of the two potential outcomes described above will probably happen, but which one? Only time will show. One thing is for sure: Treasuries need to be watched for next few months more than ever.

Mike K.