RPT-COLUMN-'Fed put' works for stocks but not long bonds: Mike Dolan

By Mike Dolan

LONDON, Sept 4 (Reuters) - The epicenter of market anxiety right now is spiking long-term government borrowing rates, and rescuing that market will be far more complicated than steadying an equities wobble.

Tighter monetary and fiscal policy would typically be the solution to worries about aggravated inflation and mounting public debt, but that prescription can also depress growth and potentially exaggerate a tax revenue problem.

Deftness is required. What's not required is easy money.

For decades, equity investors have talked about the so-called central bank "put" - options market parlance for a policy safety net that limits sharp stock losses with restorative interest rate cuts and liquidity injections.

Popularized during the tenure of former Federal Reserve Chair Alan Greenspan in the 1990s, the "Fed put" essentially worked as advertised. Authorities could justify easing policy with the need to tamp down excess volatility and business uncertainty or the argument that the "negative wealth effect" could harm the wider economy.

Many economists and market observers worried back then that encouraging this belief would encourage undue risk-taking, which largely proved correct in the lead-up to the 2007-2008 banking crash and global recession.

But central banks' decade-long response to that credit shock took the form of balance sheet expansion and money printing, resuscitating the idea that a policy put existed.

Not only have these actions skewed markets by essentially making Wall Street equities "risk-free" over the past decade, including during the COVID-19 pandemic, but they have also allowed the U.S. government - like many of its peers - to stack up ever more debt, not least because the central bank has been hoovering up many of the bonds.

One glance at the performance of long-term government bonds this year - and particularly this week - suggests markets are calling time on that debt buildup.

If so, perhaps it's time to activate the central bank put to keep debt affordable and governments solvent?

Not so fast, and not so easy.

NO IFS OR PUTS

Rising debt is only part of the problem. If it was the only issue, then lower policy rates might well work to resolve debt sustainability math.

The real worry is that unlike during much of the past two decades, we may now be approaching a "crisis" the Fed can't easily resolve.

U.S. inflation is still far above target, and the Fed's ability to deal with it is being neutralized by what many see as political capture of the central bank by President Donald Trump's administration.

If the Fed were to embark on the sort of dramatic easing campaign currently being demanded by Trump - even as the economy is growing by more than 3%, credit is abundant and financial conditions are the loosest in years - then the bond market may have to start pricing in inflation well above 2% far into the future.

The market's base case already appears to be 2.5% average inflation over the next 10 years.

At the very least, the uncertainty generated by that possibility should boost the risk premium in the U.S. bond market. And given that fiscal retrenchment is highly unlikely for the foreseeable future, it means long-term debt yields could actually rise in the face of rate cuts.

The "put" so resolutely relied upon by equity investors just doesn't work for long bonds, at least not in this environment.

The likely effect of rate cuts on the long end of the bond market is already pretty clear, given that the U.S. yield curve has steepened the most in almost 10 years as easing expectations have risen.

And while many central banks in Europe have cut rates this year even as the Fed has stalled, these moves haven't prevented their long-dated nominal borrowing rates from hitting decade-highs this week. Indeed, yield curves in Europe are now far steeper than in the U.S., where inflation worries are arguably more severe.

Back in Washington, there are persistent murmurs that this circle could be squared by pressuring the Fed to ease while the Treasury reorders the gigantic government debt stockpile, relying more on shorter tenors that benefit most from base rate cuts and reducing the holdings on the long end of the curve that could rise on inflation fears.

Such a "twist" operation could become the new and much more complicated government "put", but it would have to be sequenced and executed with great care for fear of periodic blow-ups.

And even if successful, it would do nothing to assuage market fears that inflation may not return to target in a sustainable way over the investment horizon. That concern could keep putting upward pressure on long-term debt yields as risk premia mount.

For the long-bond world, that sort of "put" appears riddled with holes.

The opinions expressed here are those of the author, a columnist for Reuters

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