FT Alphaville " Floating Treasuries. Levitating Fed. Let's start with "Federal Reserve Independence Day" - March 4, 1951. Nowadays... when financial repression is all the rage, people seem more interested in what caused the Fed-Treasury Accord of that year, rather than what happened after. It is a fascinating tale, admittedly, harkening back to a simpler time when Rick Santorum last had a chance of being President. Also a time when US government officials openly debated debt monetisation. The history is that the US central bank had committed to a cap on interest rates (such as 2.5 per cent for long-term bonds) for the benefit of the Treasury's debt management during the Second World War. In 1951, it faced being corralled into continuing the rate peg, and monetising US debt, as the Cold War turned hot in Korea. Cutting a long story short... the Fed won in the end. The fiscal authorities "lost." The peg was discontinued and the Fed established its independence for good. Just as fascinating, though, is what the Treasury did after the Accord. The agreement in theory left the Treasury with both a refinancing problem and the possibility of some very angry bondholders. They would see capital - patriotically invested in Uncle Sam in WW2 at Fed-fluffed prices - destroyed. "The President... referred to his World War I experience with Liberty bonds and said that he did not wish that to happen again," one pre-Accord meeting recounts. To deal with the problem, the Treasury announced a big bond swap. It would buy back current long-term bonds and replace them with debt bearing higher coupons: The offering of this new security is for the purpose of encouraging long-term investors to retain their holdings of Government securities, in order to minimize the monetization of the public debt through liquidation of present holdings of the Treasury bonds of 1967-72. "The Fed just said "No." [to buying the new bonds]," a 2001 narrative says. It's an interesting example of the kind of fiscal-monetary entwining that haunts markets today. But "flipped" and more like entwining-exit, we suppose. We mention the 1951 episode because Manmohan Singh and Peter Sellas do as an aside in their latest IMF paper on financial collateral as money. As we've noted, the paper makes clear that the supply of "safe" assets is an area where the central bank and the fiscal agent are forced to interact despite themselves. At times this is about retiring bad assets into the central bank as a (hidden) fiscal risk... Cf 2009′s Fed-Treasury "accord." Other times it can be what the Treasury Borrowing Advisory Committee decided in January this year - not to stand in the way of issuing Treasuries with negative yields, if that's what the market wants. It might not be what the Fed wants. Singh and Sellas reckon the TBAC's other proposal, for the US to issue floating-rate notes, has shades of the 1951 exit though: Might the U.S. Treasury go down a similar path again in conjunction with an eventual Fed exit strategy? In the current environment, markets have witnessed a 30 year secular decline in bond market yields. Serious market turbulence might result, significantly greater than that associated with the February 1994 "surprise" rise in rates initiating a tightening cycle, were the market to believe it were embarking on a steady (or rocky) rise in rates from near zero to a "neutral" fed funds rate of 400 bps and a "normal" 5 percent yield on 2-year U.S. Treasuries. The recent TBAC's proposal for floating rate notes (FRNs) seems an obvious option to cushion the transition for the market. As an indication that the eventual unwinding and normalization of the yield curve will take time and inflict pain on holders of fixed income debt, the market appears already to be requesting such "puts." We're not saying this is how, or when, a Fed tightening or QE unwind has to work. Issuing FRNs is also a debate about the merits of relieving the money market fund industry's reliance on yield-less T-bills, and also about - as in these Credit Suisse charts from last year - US debt rollover risk: At any rate (ha), fiscal-monetary entwining might not just be for credit risk. Related links: What if the UK cancelled the Bank of England's gilts? - Bond Vigilantes Anatomy of the bond market turbulence of 1994 - BIS paper This entry was posted by Joseph Cotterill on Wednesday, April 11th, 2012 at 19:31 and is filed under Capital markets. Tagged with federal reserve, government bonds, Monetary policy, qe, Treasuries.