RPT-ROI-Warsh's arrival leaves long bonds without a safety net: Mike Dolan

Whatever the route or timetable, there seems little chance that Warsh would support any further buying of long-term debt - 10-year tenors or longer - even in a fresh shock or crisis. That leaves the very long end of the market without the effective safety net it's enjoyed for 18 years since the Fed first launched quantitative easing (QE) after the 2008 banking crash.

Investors may now be discovering what long-term government ​borrowing costs are really like when you remove the potential backstop of central bank intervention from the bond market. The main ​driver of surging U.S. long-bond borrowing rates this year is clear enough: the Iran war, ‌the ​related oil shock, racing inflation and the inevitable speculation about interest-rate rises.

Thirty-year Treasury yields have risen more than 50 basis points since the war began, topping 5.15% for the first time since before the Global Financial Crisis in 2007. But that milestone also reflects another factor that's aggravating the sudden repricing of the debt market. Bonds have not traded without either actual central bank buying or the implicit threat of it ‌in a shock since 2007.

Now enter Kevin Warsh as the new Federal Reserve chair. Warsh is a longstanding public opponent of Fed bond-buying - he ostensibly resigned from the Fed board in 2011 over the issue - and a staunch advocate of running down the central bank's $6.7 trillion balance sheet of mostly Treasury securities.

"Working with the Treasury Secretary, we're going to have to find a way in which we can take the balance sheet and make it smaller," he said at his confirmation hearing last month. TORN SAFETY NET

Investors have pored over the "ifs" and "buts" of how that might ‌even work were Warsh to get his way. What seems clear to most Fed watchers is that it couldn't happen immediately, especially not in the current market environment.

The argument for running down the balance sheet centers on first shortening the maturity of its holdings to ‌Treasury bills of 12 months or less and then being able to more easily run them off as those bills mature. Whatever the route or timetable, there seems little chance that Warsh would support any further buying of long-term debt - 10-year tenors or longer - even in a fresh shock or crisis.

That leaves the very long end of the market without the effective safety net it's enjoyed for 18 years since the Fed first launched quantitative easing (QE) after the 2008 banking crash. QE came in subsequent waves and was repeated on a large scale during the COVID-19 pandemic in 2020. Its main purposes were to stabilize imploding credit markets and push borrowing costs lower even though Fed policy rates ⁠had reached an effective ​floor near zero.

The Fed's balance sheet has been reduced from its post-COVID peak ⁠of $9 trillion, but more than a third of the remaining $6.7 trillion still consists of Treasuries with maturities of 10 years or longer. The direct impact of QE on Treasury yields has long been debated, with no agreed or precise estimate of its effect on either the economy or the debt market.

Many investors assumed, at least, that ⁠the historically low - and often negative - term premium in long-term Treasuries reflected the lower perceived risk when an active Fed balance sheet served as a parachute for creditors in a crisis. Barclays strategists, outlining what the Fed might do if the yield spike became a rout, reckon most options are off the agenda - especially ​outright purchases.

"This does not seem likely to us given Warsh's past criticism of Fed balance sheet policy," they wrote. WITHOUT A PARACHUTE

The share of Treasury debt in 30-year and 20-year maturities - which go under the hammer this week - is small ⁠at just about 3%. Long-term debt, however, tends to be held in portfolios of securities with maturities of 10 years or more. With the 10-year as the benchmark, the share of outstanding Treasuries in that bracket rises to some 25%, giving sharp moves in the long bond an outsized influence on overall pricing. To gauge where 30-year yields might sit ⁠in ​the absence of that 18-year Fed backstop, Barclays compared the current spread between 30-year yields and the Fed policy rate against its historical range.

The current spread of 150 basis points is still below the historic average of 180 bps - and even adjusting for extremes in the policy rate, it comes in at around 150 bps. "This simple exercise tells you that bonds are not cheap," they added.

In an economy where the absence of Fed easing collides with a deteriorating fiscal outlook and rising assumptions about the long-term neutral rate - driven in part by an ⁠AI productivity boom - the scope for further 30-year yield gains looks real. If the Fed is forced to hike rates, it could go higher still. Barclays put a number on it: "5.5% does not seem far-fetched."

Other factors could yet calm markets. The Treasury could reduce sales of ⁠super-long-term debt or even suspend the 20-year tenor. But that merely loads ⁠ever more debt into bills and possibly even the more influential 10-year benchmark. In the end, the mere uncertainty about how markets would react to the next shock - without the certainty of Fed intervention - may be enough to demand a higher risk premium anyway.

(The opinions expressed here are those of Mike Dolan, a columnist for Reuters.) Enjoying this column? Check out Reuters Open Interest (ROI), your essential new source for global financial commentary. Follow ‌ROI on LinkedIn, and X. And listen to ‌the Morning Bid daily podcast on Apple, Spotify, or the Reuters app. Subscribe to hear Reuters journalists discuss the biggest news in markets and ​finance seven days a week. (by Mike Dolan; Editing by Marguerita Choy)