QE2 Sends U.S. Interest Rates Higher

By: Mike_Larson

So if the latest reporting is to be believed, QE2 is a fait accompli.

The Wall Street Journal on Wednesday said the Federal Reserve plans to purchase “a few hundred billion dollars” worth of Treasuries over a period of “several months.” The Fed will stick largely with Treasury notes, rather than bills or bonds, with the lion’s share of the buying focused on securities with maturities between two and ten years.

The Fed’s goal? According to the Journal, “to drive up the prices of long-term bonds, which in turn would push down long-term interest rates.”

Here’s the thing, though. Maybe I’m the only one with an Internet connection or an eSignal data feed. But it sure doesn’t look to me like long-term yields are FALLING. Instead, they’ve been RISING — sharply and swiftly.

Take a look at this chart of the 30-year Treasury Bond yield. It has shot up from 3.46 percent in late-August to 4.06 percent earlier this week. That’s a 60-basis point rise in only two months! Long bond futures have shed seven full points in price during that time.

In plain English, the bond market is telling Ben Bernanke to take a hike!

Why QE2 Is Having Precisely the OPPOSITE Effect It’s Supposed To

There are a lot of reasons why I think QE2 is a dumb idea. It’s the wrong medicine for what ails the U.S. economy. It’s untested and risky. And most importantly, if QE1 failed to reinflate the specific markets it was targeted at — housing and mortgages — why the heck does anybody think a smaller, less focused QE2 effort will work?

But the recent market action proves things are even WORSE than I feared …

QE2 isn’t just failing to drive rates down. It’s actually doing precisely the OPPOSITE of what the Fed wants — driving rates UP! The yield on the long bond hasn’t been this high in almost three months, while the 10-year yield is climbing fast.

Why is this happening? Because QE2 is torpedoing the U.S. dollar and fanning real inflation fears!

The Fed’s monetary policy has pushed the dollar off a cliff while driving commodities up.

The dollar index has plunged as much as 14 percent since June. Meanwhile, crude oil has surged as much as 31 percent … soybeans have climbed up to 32 percent … cotton has skyrocketed 72 percent … corn has jumped 75 percent … and wheat has shot up 85 percent. Gold, silver, copper, and other metals are flying, too.

In fact, inflation concerns have ramped up so much that Uncle Sam just sold a batch of $10 billion in 5-year Treasury Inflation Protection Securities at a negative interest rate. Yes, you read that right …

Investors bid so aggressively for the TIPS that they bore a coupon interest rate of MINUS 0.55 percent — the first time that has ever happened in U.S. history!

Why would anyone do that? Because the total return on TIPS doesn’t just stem from the fixed coupon yield they pay throughout their lifetime. The principal value of the securities also adjusts along with changes in the Consumer Price Index.

Bond investors were willing to accept a negative yield now because they believe future inflation will ramp up. That would drive the ultimate return they earn over the life of the securities high enough to compensate for the negative initial yield.

Unintended Consequences, Take Three

As inflation takes hold, shoppers will be forced to struggle with soaring prices on everyday necessities.

My conclusion? Once again, a recklessly easy monetary policy put in place by the Fed is having painful, unintended consequences …

We saw this in the late 1990s, when easy Fed money helped inflate the tech stock bubble. We saw this in the early 2000s, when easy Fed money helped inflate the housing bubble. And now, we’re seeing it again.

The Fed’s policy is NOT creating jobs. It’s NOT leading to a huge new boom in the economy. But it IS jacking up prices on a wide range of commodities and crushing the dollar, making it more expensive for companies and consumers to earn a living and pay their bills.

I wish we could just vote Bernanke out of office before he wrecks the economy again. But we can’t. All we can do as investors is take steps to protect ourselves from the Fed’s lunacy.

When it comes to your fixed income portfolio and your interest rate strategy, that means keeping the maturity on your bonds short.

You can also hedge yourself against declines in the price of long-term bonds using tools such as inverse exchange traded funds (ETFs). Looking for more specific details? Then check out Safe Money Report.

Until next time,

Mike

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