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Interest rates Vs. Yields

Written by A Forex View From Afar on Monday, February 09, 2009

Even though the Fed has pledged to maintain the key interest rate at very low levels for an extended period, the yield on the longer loan instruments rose at a strong pace in the last month.

In the financial markets, governments and corporations use bonds to issue new debt and finance their activity. The yields on these bonds represent how much the entity would have to pay for its loan, so a lower interest rate is in its advantage. In order to conduct the monetary policy, the Fed influences only short-term rates, up to a year. However, the Fed has no direct control over the longer-term yields, but it tries to influence them through a whip effect.

Moreover, these longer-term bonds, such as the 10 and the 30-year, have risen quite spectacularly lately. From the beginning of the year, the yield on the 10-year bond rose by 30%, from 2.40 to 2.90 points, while the yield on the 30-year bond rose 35%, from 2.81 points to 3.68 points

As the yields on the U.S. government debt rises, it raises the marginal cost of holding cash reserves, and thus it undoes the Fed’s rate cuts. In addition, these higher yields are sent all over the market, raising the cost of mortgages, personal loans and adds a crucial weight to the U.S. debt, especially now, when the 2009 budget deficit forecasts are measured in $ trillions.

Lately, there have been strong speculations that the Fed would be tempted to start buying treasuries in the primary and in the secondary markets with a maturity longer than a year, in an attempt to further expand its balance sheets. Nevertheless, this holds a major problem, because it will assure investors that they will be able to find a counterpart in the Fed, tempting sellers to sell at a higher price. In other words, the Fed is willing to assure the demand side, disrupting the supply-demand relationship.

If the Fed will really start buying long-term treasuries, its implications in the currency market would be adverse. Firstly, it would allow investors to run out of dollar denominated assets in other risky assets, searching for a higher yield, which would be dollar negative. During this time, the yield on treasuries will remain relatively flat, or it will head somewhat lower (which indicates risk aversion), but still the dollar would lose ground.

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There is a constant question from some traders as to why anybody would ever need to consider the ‘F’ word when trading. Fundamentals: what is so damaging at looking at both Technical charts and having a Fundamental filter to gauge how many Lots to put on? Why is it that accepting that Technicals give us price points to trade, but Fundamentals determine the direction that we travel is so difficult for some traders to accept? Without a Fundamental Filter very few pure Technical traders would have seen this Dollar move coming today.

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