Problems for the Fed Reserve.

Even if the Fed does not lift interest rates Analysts at Deutsche Bank see the liquidation of US Treasuries by China, Russia and Emerging Market countries – as a liquidation trend – holding for quite some time.

The First Fed Problem?

The problem is finding new categories of buyers to replace these Central Bank sellers.

This changing dynamic – brought about by the Fed Reserve’s stated policy – small increases on rates over a number of years – will tend to lower bond prices, and increase bond yields.

Whereby the bond yields – move in the opposite direction as to the price.

Citibank – estimates that every $500 billion in Emerging Markets FX drawdowns will result in 108 basis points of upward pressure placed on the yields of 10-year U.S. Treasurys (As reported in Bloomberg – link below).

This means that if just China were to dump its $1.1 trillion in Treasury holdings, U.S. interest rates would be about 2% higher.

Not that they will mind you – it will take time to dispose of these holdings in an orderly manner – the buyers will seek a discount – lower principle value – increase return to offset the Fed’s new policy.

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Image courtesy of investing.com, click on image – but it only gets bigger – not better.

The Second Fed Problem?

Yellen has indicated the Fed’s desire to allow its current hoard of Treasuries to mature without rolling them over.

The intention is to shrink the Fed’s $4.5 trillion dollar balance sheet back to its pre-crisis level of about $1 trillion – that means – in addition to finding buyers for all those Bonds being dumped on the market by foreign Central Banks – the Treasury may also have to find buyers for $3.5 trillion in Bonds that the Fed intends on not rolling over.

The Fed has stated that it hopes to effectuate the drawdown by the end of the decade, which translates into about $700 billion in bonds per year. That is a lot of money and as Yellen has stated – an incremental increases over a longer time period – who would want to buy these Bonds at low yields?

So The Conundrum

Regardless whether the Fed is preparing to raise rates on the short end of the curve, forces beyond the Fed’s control will be pushing rates up on the long end of the curve.

This – over time – will seriously undermine the health of the U.S. economy – even while many signs already point to near recession level weakness.

There is nothing that Yellen can do to stop the markets setting the rates – if this happens – then Yellen will be caught in a useless loop of her own making – increasing rates to offset market rates.

Who said you can’t fight the Fed?

Just sit back and enjoy the roller coaster ride – weird gets weirder.

http://www.bloomberg.com/news/articles/2015-08-27/china-said-to-sell-treasuries-as-dollars-needed-for-yuan-support

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