Forex Robot: Usd/Treasury Links In Unchartered Waters

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TheLFB Daily Client Note
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Client Note: U.S. Session Preview

March 29, 2011
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Trade Desk Note

The Dollar/Treasury Link

The Federal Reserve historically controls overnight lending rates by increasing
or decreasing the flow of Treasury Notes. Historically, when rates need to go lower,
the Fed buys back from the market a swath of existing Treasury notes, therefore
decreasing market liquidity and increasing the existing note values.
By increasing the value of the note, the reaction is for the yield (interest rate)
to be automatically decreased. Lower interest rates come from less notes in circulation.
Historically, when rates need to go up, the Fed sells more Treasury notes, therefore
reducing existing note values and increasing the yield (interest rate). That move
makes more money available to be lent out into the economy; it increases the yield
on the existing notes in circulation, and automatically increases overall market
interest rates.
In a final gesture, the Fed should look to be banking the cash received from the
sale of those notes into their Reserves, so it can then be used in the next cycle
of rate changes. And that is the longer-term query; Reserve amounts are not in-line
with forward debt obligations, and more notes are being printed than can ever be
repaid from current GDP forecasts.
That may be the historical way that the Fed controls interest rates, but the fly
in the Administration (read Treasury Dept. and Federal Reserve) ointment is the
fact that there has never been this amount of notes coming to market, and being
made available. The constant flow of new notes is devaluing the existing and automatically
lifting Treasury yields (interest rates).
At a time when the Fed is absorbing new notes being printed by the Treasury, so
that the stimulus packages can be put into action and cash created to invest as
the Administration wishes, the automatic response is for 10-year yields to rise.
The 10-year Treasury note has the greatest impact on the U.S. economy due to its
influence on long term interest rates.
While the Federal Reserve controls the overnight rate, interest rates paid on long
term financing for capital goods, as well as the housing market, are established
by asserting a premium over the 10-year Treasury note value. In other words, whatever
the 10-year note is worth determines the rates for mortgages, investments and inter-bank
loans that are set from the 10-year yield rates.
Some may feel that the Fed is withholding vital information regarding the danger
of the U.S. economy not easily coming out of the recessionary phase. There has
been no public announcement of any exit strategy to try to unwind the ever-increasing
yield (read mortgage, credit card, auto, commercial real estate, borrowing costs)
which has created wider spreads in the value of insuring against default on the
notes (credit default swaps). This has also impacted the cost of banks doing business
with each other and their willingness to leave risk on their balance sheet for any
sustained period of time.
The fact that the Fed has no choice but to buy back any amount that the market will
not bid freely on, and their commitment to QE2 POMO buy-backs is creating the same
higher rates that the Administration may need to reduce in order for the economy
to more easily grow, and for the Administration to be able to afford the cost of
debt funding. The Fed did its job in creating global liquidity, the Treasury is
doing its job of creating government debt and generating cash, and the Primary Dealers
have done its job of buying equities and commodities that were back-stopped by the
Fed and regional central banks.
Now that quantitative easing may be phased out sooner than originally thought, and
taking out the cost of insurance that the U.S. government stays solvent, it may
be more easily seen why the Usd may start to get bought.
If there are no cash Reserves getting built from the sale and part buy-back of new
notes, and no more QE programs, what will be used to stimulate the next business
cycle drop? And, more importantly, once the required amount of notes have flooded
the market, and yields have exploded, how is the Fed going to repatriate interest
rates? In a strange twist of fate, it may be that higher interest rates instigate
a stronger Usd. The economic cost will remain an unknown, as the Federal Reserve
floated their QE boat into unchartered waters.
Another relationship of note is between the Treasury bond's price, and the interest
rate or premium it offers at any time. It is an inverted relationship; when bond
prices increase, the yield (interest rate) moves lower, and vice-versa. This all
comes from the fact that at maturity repayment of the principle is paid at par value,
and not at bond's market price. Par value = Current Interest Rate/Price.

Example:

A $1000 10-year Treasury note, with a 4% Interest Rate = $1000 x 4% = $40 guaranteed
a year, for 10 years.

If the market price of the note goes down, because of increased amounts of notes
hitting the markets, from $1000 to $500 for example, then the interest rate math
changes.

The same $1000 bond with a 4% interest rate is still guaranteed to pay 4% a year,
but now that it has an open market value of $500, and it is still returning $40,
the interest rate, or Par, is now 8% for as long as the note value holds $500.

It should be pretty clear that the best way to trade bonds is usually during recessionary
times, when bond prices increase due to repeated rate cuts, and in times of equity
selling.
The variable here is the unknown QE2 exit strategy, and how the Fed is going to
stimulate the economy while still containing interest rates. That scenario is creating
fear of loss, sideways forex trade, and volatility that has no release valve.
Updates to this article will be sent via TheLFB daily client notes.
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