Should the Fed start buying Treasury bonds to hack rates?

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While Congress debates how best to spend hundreds of billions of dollars to buttress the sinking economy, Federal Reserve policymakers meeting today will be considering a multibillion-dollar spending question of their own: Whether to buy longer-term U.S. Treasury bonds for the Fed’s own portfolio.

With its benchmark short-term interest rate already at rock-bottom, the Fed has no more leverage to influence market rates with that tool. So the central bank last month raised the possibility of buying T-bonds as a way to pull longer-term interest rates down.

Because rates on corporate bonds, municipal bonds and mortgages are loosely pegged to Treasury yields, in theory the Fed could help lower borrowing costs for companies, municipalities and home buyers by depressing Treasury rates.

What’s more, having the Fed as a buyer could keep longer-term Treasury yields from rising in the face of the record sums the government is expected to borrow this year to finance bailouts of the financial system and economy.

‘There’s a supply tsunami coming’ in T-bonds, notes Dominic Konstam, interest-rate strategist at brokerage Credit Suisse in New York.

In recent weeks, supply concerns have helped fuel a whiplash in yields on 10-year and 30-year Treasuries from last month’s record lows, although rates still are far below where they were in mid-summer.

Given the upturn in yields, the Fed’s post-meeting statement today ‘may use a more threatening tone to warn they are moving closer to buying Treasuries,’ Merrill Lynch economists Drew Matus and David Rosenberg said in a note to clients on Tuesday. . . .

At the very least, that could give traders pause before ‘shorting’ bonds -- a bet on higher yields.

But some analysts believe the Fed would be making a mistake to step into the Treasury market. Lou Crandall, chief economist at bond broker Wrightson ICAP in Jersey City, N.J., says Treasury purchases by the Fed would smack of ‘gimmickry’ that could heighten foreign investors’ concerns about U.S. finances.

Foreigners’ perceptions are critical, of course, because we need their capital -- more than ever.

Fed policymakers, Crandall said, should be trying to present the image that the U.S. is confident about its long-term finances and in its ability to remain a magnet for foreign investors. Having the Fed step into the Treasury market to manipulate yields wouldn’t be a confidence-builder, he said.

A better plan, Crandall said, would be for the central bank to continue buying mortgage-backed bonds in an effort to pull home-loan rates lower. That’s a way to directly target mortgage rates, as opposed to the indirect route of buying Treasuries.

He also noted that the Fed can justify buying mortgage bonds by arguing that yields on those securities are too high relative to falling inflation.

By contrast, with Treasury bond yields already so low, Crandall said, ‘They’d be buying an instrument that is already perceived to be overvalued.’

-- Tom Petruno