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Shark in the bond tank

By Sheyna Steiner · Bankrate.com
Tuesday, February 14, 2012
Posted: 1 pm ET

The introduction of new predators into an existing ecosystem wreaks havoc. That may be the case with today's Treasury market.

With the introduction of a mammoth bond buyer in the form of the Federal Reserve conducting Operation Twist, the natural habitat of the bond market has been altered. When there is a great demand for bonds, in this case, long-dated Treasury securities, yields fall. With a big buyer snatching up lots of issues, prices are higher, yields are lower -- and there are fewer available for other buyers.

"This confluence of factors has caused a rapid shrinking of the number of 30-year bonds that are available to trade, and it is also distorting the 30-year bond yield's role as an important gauge of inflation expectations," writes Min Zeng for the Wall Street Journal in the Feb. 10 story, "Fed's 'Operation Twist' tangles Treasury trade."

With the Fed distorting prices and yields, investing in bonds has gotten less predictable. There's also the possibility it could become even less so.

From the story:

There are worries that the end of Operation Twist, scheduled for this summer, could introduce volatility and catch the legions of investors in 30-year bonds off guard.

"If the Fed ends the Twist 'cold turkey' at the end of June," asks Ward McCarthy, chief financial economist at Jefferies & Co., "will long-term rates snap higher? Policy makers will start to think about this before the end of June."

It could go either way, a strong economy could send yields higher. But if the economy stumbles again or global events send investors on a flight to safety, yields could remain suppressed.

For a broader context and a somewhat more chilling conclusion, The Economist this month features a story on government bonds titled "Oat cuisine: A stodgy asset class has become more complex and more dangerous." It's also found on their website, Economist.com.

The danger for individuals lies in the fact that they are getting negative real yields as a result of all the high-level machinations. And central banks may have some hidden motives for their bond-buying programs.

From the story:

Carmen Reinhart, Jacob Kirkegaard and Belen Sbrancia, three academics, have suggested that governments may use “financial repression”—forcing debts down the throats of captive buyers and keeping real rates negative so that inflation eliminates their debts. This trick worked after the second world war. The presence of “forced buyers” in the market such as central banks and commercial banks may enable it to be repeated …

This is a vital issue since a sudden surge in bond yields might wreck government finances, economic prospects and the outlook for other asset markets.

What do you think? Either way, individual investors are getting the short end of the stick here. If bond yields remain very low, it's good for the government while savers lose purchasing power hand over fist.

If the economy surges and yields increase, how severe could the consequences be? Could it be what the inflation hawks were warning of all along?

Guess we'll see what happens.

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