Treasury bond market taunts Fed as yields jump

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Rising yields on Treasury bonds are testing the Federal Reserve’s pledge that it stands ready to buy those securities to keep interest rates in general down.

Bond traders now may be playing a game of chicken with the central bank, pushing up yields to see how much the Fed will brook.

The yield on the 10-year T-note -- a benchmark for mortgage rates -- reached 2.94% today, up from 2.84% on Tuesday and the highest since Nov. 27.

At the end of last year the 10-year T-note yield fell as low as 2.06%.

Although some rebound had been expected, ‘The question is, where is the Fed willing to draw a line in the sand?’ said Tom Tucci, head of the Treasury trading desk at RBC Capital Markets in New York.

With its benchmark short-term interest rate already at rock bottom, the Fed can’t make any more use of that tool to influence market rates. So the central bank in mid-December signaled that it might buy Treasuries for its own portfolio as a way to pull longer-term rates down or at least keep them from rising.

The Fed, led by Chairman Ben S. Bernanke, went a step further after its meeting last week, saying it was ‘prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.’

Here’s the problem the Fed faces: Traders and investors have some legitimate reasons to push Treasury yields up from their recent record lows. For one, Wall Street knows it is facing a massive supply of new government debt to fund the financial-system bailout and economic stimulus plans.

The Treasury today said it would borrow $67 billion next week alone via sales of three-year, 10-year and 30-year bonds. To attract enough buyers, the government may just have to pay more.

Also, part of the reason why Treasury yields have snapped back this year is that some investors have been selling Treasuries to buy higher-yielding securities -- including corporate and municipal bonds. That’s a good sign for the financial system, because it suggests that investors are becoming less fearful about taking risk.

‘Corporate bond issuance was very robust in January, a sign of better credit market conditions,’ noted Tony Crescenzi, bond strategist at Miller, Tabak & Co. in New York.

Still, rising yields on long-term Treasury bonds aren’t helping the mortgage market. Home loan rates have ticked up since mid-January.

But that also may be exposing the limits of the Fed’s power to influence long-term interest rates: Mortgage rates are higher even though the Fed has been buying mortgage-backed securities for its own portfolio since early January.

That raises the question of whether the Fed would just be wasting financial ammo if it tries to mess with the market by buying Treasuries as well.

-- Tom Petruno