Long-term T-bond yields defy the Fed, inviting a showdown

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Just how much more can the Federal Reserve do to push down long-term interest rates? Chairman Ben S. Bernanke and cohorts may want to tell us today -- because yields in the Treasury bond market aren’t going the way the Fed had hoped.

On Tuesday, another surge in long-term T-bond yields set the scene for today’s wrap-up of Fed policymakers’ spring meeting. The 30-year T-bond jumped to 3.95%, up from 3.84% on Monday and the highest since mid-November.

The 10-year T-note yield, a benchmark for mortgage rates, rose to 3% from 2.92% on Monday.

The last time the 10-year T-note was at 3% was on March 17 – one day before the Fed stunned the bond market by announcing plans to buy up to $300 billion of Treasury securities by fall, in a move to try to rein-in longer-term interest rates.

That announcement had the desired effect: The 10-year T-note yield dived to 2.53% on March 18, losing nearly a half-percentage point in one session, an astounding move.

Since then, however, yields on long-term Treasuries have been edging back up even as the Fed has been actively buying government securities for its own portfolio as promised.

The Fed could argue that the rise in yields might have been a lot worse: The central bank has been up against a swelling supply of new Treasury notes and bonds as government borrowing soars to finance economic-stimulus measures and the financial-system rescue.

That tsunami of borrowing is what spooked the bond market on Tuesday. First, the Treasury had to pay slightly more than expected at an auction of $35 billion in five-year notes. Second, rumors swirled that the government today might announce a major expansion of 30-year bond sales -- fueling fears that supply finally might threaten to overwhelm investor demand.

The main risk for the economy is that higher Treasury yields could put upward pressure on mortgage rates, dealing another blow to the devastated housing market. In recent weeks, though, 30-year home loan rates have just been treading water, holding around 4.8% on average.

The Fed has been directly intervening in the mortgage market, too, by purchasing mortgage-backed bonds.

The question facing the Fed today is whether to try another ‘shock and awe’ announcement to push Treasury yields lower again, said Ashraf Laidi, chief market strategist at CMC Markets in London. . . .

The Fed could, for example, announce that it is doubling or tripling the amount of Treasuries it will buy in the next five months or so, from the original $300-billion pledge. In theory, there is no limit to what the Fed can buy because it essentially creates money out of thin air.

The risks of this new Fed strategy are legion, not the least of which is the threat to the central bank’s long-term credibility. But in the short run, more massive buying of Treasuries would make traders think twice about betting against the Fed.

Or Bernanke and crew could just opt to sit tight for a while, hoping that in a still-awful economy, with inflation fading, there’s no reason for the market to push bond yields up significantly from here.

But if investors and traders have other ideas, the Fed will have to react, says Joe LaVorgna, chief U.S. economist at Deutsche Bank in New York.

‘We believe that if yields on 10-year Treasuries rise meaningfully above 3% for a few weeks, and if mortgage rates rise in unison, the Fed will be forced to substantially increase purchases of Treasuries beyond its current intention,’ LaVorgna said.

-- Tom Petruno