Long-term U.S. Treasuries face severe challenges, but the "Federal Reserve put option" is no longer a panacea

According to the Zhitong Finance APP, there is still a pervasive sense of anxiety in the current U.S. capital markets, primarily due to the surge in long-term government borrowing rates. The difficulty in resolving this crisis is far greater than stabilizing the volatile U.S. stock market. Generally speaking, tightening monetary and fiscal policies are solutions to address rising inflation and high government debt, but this "prescription" may also suppress U.S. economic growth and further exacerbate tax revenue issues.

Reuters market analyst Mike Dolan believes that the current situation requires a "nimble response" in policy rather than "loose monetary policy."

For decades, stock investors have been discussing the Federal Reserve's "Central Bank Put," a term from the options market that refers to the Federal Reserve's construction of a policy safety net through interest rate cuts and liquidity injections to limit significant declines in the stock market.

In the 1990s, during the tenure of former Federal Reserve Chairman Alan Greenspan, the concept of the "Federal Reserve Put" began to gain popularity, and its actual effects were generally consistent with expectations. Authorities could always find reasonable justifications for loose policies: either to curb excessive market volatility and corporate operational uncertainties or to address concerns that the "negative wealth effect" (where stock market declines reduce public wealth and lower consumption willingness) could harm the overall economy.

At that time, many economists and market observers worried that the expectation of the "Federal Reserve will backstop" would encourage excessive risk-taking behavior, and it proved to be a reality before the outbreak of the 2007-2008 banking crisis and global economic recession.

However, in response to that credit crisis, the Federal Reserve implemented measures of balance sheet expansion and money printing for a decade, which revived the notion of the existence of a "policy put."

Over the past decade (including during the COVID-19 pandemic), these measures not only made Wall Street "almost risk-free" in essence, distorting normal market logic; they also led the U.S. government (like many other governments) to accumulate more debt, especially as the Federal Reserve has been buying large amounts of government bonds to "absorb" government debt.

Observing this year, particularly the performance of long-term government bonds this week, it seems that the market has "flashed a red light" on this debt expansion model. If so, perhaps it is time to activate the "Federal Reserve Put" to ensure that debt remains manageable and the government has the ability to repay, but in reality, the timing is still not right, and it is certainly not an easy task.

The "Put" is Not a Panacea

Dolan stated that rising debt is only part of the problem. If this were the only issue, then lowering policy rates might suffice to solve the mathematical problem of debt sustainability.

What is truly concerning is that, unlike most periods over the past twenty years, we may currently be facing a "crisis" that the Federal Reserve finds difficult to resolve easily: U.S. inflation remains well above target levels, and many believe that the Federal Reserve's ability to manage inflation is being undermined by the "political manipulation" of the Federal Reserve by the Donald Trump administration.

Currently, the U.S. economy is growing at over 3%, credit is abundant, and the financial environment is at its most accommodative state in years. If the Federal Reserve continues to initiate large-scale easing policies at Trump's request, the bond market may have to incorporate the expectation of "long-term inflation significantly above 2%" into pricing.

The current market's basic expectation seems to be that the average inflation rate over the next ten years will reach 2.5%. At the very least, this inflation uncertainty will push up the risk premium in the U.S. bond market. Moreover, considering the extremely low likelihood of fiscal tightening in the foreseeable future, this means that even if the Federal Reserve cuts interest rates, long-term Treasury yields may actually still rise.

The "put options" that stock investors rely on are ineffective for long-term bonds, at least in the current environment.

Meanwhile, Dolan believes that the potential impact of interest rate cuts on the long-term bond market is quite clear: as market expectations for Federal Reserve rate cuts heat up, the U.S. Treasury yield curve has steepened to the greatest extent in nearly a decade (with long-term yields rising significantly more than short-term yields).

Additionally, although several central banks in Europe have initiated rate cuts this year while the Federal Reserve has not yet acted, these measures have not prevented long-term nominal borrowing rates in Europe from rising to a ten-year high this week. In fact, the yield curve in Europe is now much steeper than that in the U.S., even though inflation concerns in the U.S. should theoretically be more severe.

There have been ongoing rumors that this contradiction could be resolved through a dual approach: on one hand, pressuring the Federal Reserve to cut rates, and on the other hand, having the U.S. Treasury adjust the maturity structure of its massive government debt, relying more on short-term bonds (which benefit most from benchmark rate cuts) while reducing the issuance of long-term bonds (whose yields may rise due to inflation concerns).

This "Twist Operation" could become a new and much more complex form of "government put option," but it must be carefully planned and executed to prevent a cyclical market collapse Even if this operation is successful, it cannot alleviate the market's core concern: throughout the investment cycle, inflation may not sustainably fall back to target levels. As risk premiums continue to rise, this concern may persistently exert upward pressure on long-term Treasury yields. For the long-term bond market, such "put options" appear to be full of loopholes and difficult to be effective