Although treasury yields have risen around 30 bps over the past couple of weeks, yields have not yet reached what the Federal Reserve itself might call equilibrium. The FOMC rate forecasts that the Fed published earlier this year reveal an intriguing inconsistency between the Fed’s actions and its own market forecasts. Operation Twist and its predecessors are intended to drive down long term borrowing costs, to the benefit of those who can access those markets (qualified homebuyers through mortgages, investment grade corporations and of course the Federal government itself). This along with concerns about Europe have pushed yields lower.
The Fed published rate forecasts from each FOMC member earlier in the year. Their interest rate forecasts are at odds with the term structure of interest rates, which the Fed of course is heavily influencing. The FOMC expects the long run, equilibrium Fed Funds rate to be around 4%. Although they don’t say when the rate will reach that equilibrium level, it seems reasonable to suppose that their forecast horizon wouldn’t be longer than five years. And yet, the 5 year forward treasury rate in five years (derived from the five and ten year treasury yields) is around 3.5% (it was close to 3% before yields began rising recently). The market forecast for short term rates in five years is 0.5% lower than the FOMC’s forecast.
It’s not a huge difference, but what’s interesting is that the Fed’s Operation Twist, by forcing long term yields down, is at odds with their own rate forecasts. By their own admission they don’t believe long term bonds at current yields are a good investment. Their own actions, based on their own forecasts, are not designed to be profitable for them or for anyone following them.
Corporate bond issuance has been running at record levels so far this year, spurred by corporations wishing to lock in low rates. Retail investors have happily taken the other side. The question is, since the Fed is clearly a non-economic buyer and is forcing yields down to levels that their own rate forecasts show to be unprofitable, should this be made more explicit to the retail investors that are buying at current levels? If the government is consciously seeking to make some investment uneconomic, shouldn’t they just say that in plain English? This isn’t critical of Operation Twist or earlier efforts by the Fed to maintain low long term rates – such moves have so far probably been good.
But when retail investors hiding in fixed income start to see losses on their holdings, they might wish the Fed had told them more clearly the risks they were facing. Long term bonds are still a poor investment.