Thirty Year Yield Approaching 3%, Now What?

On August 2 I had stated a strategy of maintaining my position in 30-year treasuries until the yield dipped below 3%. Well, thanks to the recent announcement by the Federal Reserve the yield is now around 3%. My position in treasuries is based on my Sagflation theme and its current deflationary outlook. The announcement by the Fed hastened a drop in yields I expected to occur over the next year. The question now becomes what to do with the position?

One of the biggest problems with the Federal Reserve buying treasuries is that it sends contradictory signals into the market. On the one hand, a large buyer should drive prices up and therefore yields down. On the other hand, the purchase is designed to stimulate the economy and therefore yields should rise due to the potential for rising economic growth and inflation. In short, the intervention in the markets makes it difficult to understand what the market is signaling.

In relation to 30-year treasuries, the announcement said specifically that the Fed plans to use 29% of the $400 billion devoted to "operation twist" to buy treasuries with a duration of 20 to 30 years, or about $116 billion, up until June 2012. This amount is the estimated amount of new issuance in 30-year treasuries over the next year. Thus it effectively soaks up all of the anticipated treasuries to be sold, unless the issuance increases significantly.

So what happens from here? Where is the bottom for the 30-year yield? I believe the yield likely continues to decline, driven by both anticipated Fed purchases and a darkening economic outlook. In short, I do not believe the announcement by the Fed can have a significant positive impact on the future economic growth for the following reasons:

(1) This policy hurts the banks and insurance companies by flattening the yield curve. This is reinforced by Moody's decision to downgrade the debt of many of the banks after the Fed's announcement. Moody's argues the government is less willing to bail out troubled banks during a recession. All I can say to this point is that hopefully this is not an issue we have to face. A less healthy financial sector likely points to worse economic conditions.

(2) By lowering yields on the longer-term treasuries the Fed hopes, in part, to enable a wave of re-financing by homeowners. There are a couple problems with this strategy. The spread between mortgages and treasuries can expand, the "bang-for-the-buck" is relatively small to homeowners, and many homeowners cannot re-finance due to a lack of equity in their house and high fees. Maybe Congress enacts a procedure to help re-finance, but I wouldn't hold my breath for Congress to do anything. As a result, I believe the stimulus of the Fed's actions are relatively weak.

(3) By raising the yield on shorter duration treasuries it actually aids the dollar. This is good in the respect that it provides the US consumer with more purchasing power on imports. However, it also likely weakens US manufacturing and strengthens the deflationary pressures in the economy as commodity prices decline, and thus reverses recent inflationary pressures. If the consumer was in a healthier economic position with less debt, I would argue that demand would pick-up as prices fall. My problem is that the debt outstanding likely keeps a more muted demand outlook. As the CPI declines, one would expect longer-term yields to decline, thus further hurting the financial institutions.

(4) By committing to soaking up all of the anticipated 30-year issuance over the next year, the Fed has effectively reduced the risk of investing in this instrument. In a world of increasing systemic risk, investors are looking for safe places to park their cash. The longer-term treasuries just became more attractive to them.

(5) Pensions for companies and governments are likely hurt by the lower yields. Pensions that need to adjust down their expected future returns due to the lower yields suddenly require large infusions of cash to make up funding shortfalls. Furthermore, the lower yields makes it more difficult for pensions to invest their funds without taking on greater risk. In a time of budget deficits in many states and a weak economy, this could provide a significant drag as states are forced to cut spending in other areas to shore up their pension funds.

I believe we can expect many other side effects to the Fed's announcement, many of them not pleasant. For all of these reasons I plan to hold onto the treasury position for the foreseeable future as I ride the buying power of the Federal Reserve and try to avoid volatility in the equity markets.