Over the past few days, I’ve been reading and rereading Ben Bernanke’s Jackson Hole speeches from the past two years. Arguably, his 2010 speech paved the way for what would be called “QE2,” the second round of large-scale Treasury purchases. I’ve read through many of the reactions that followed his speech two years ago, and most people did not immediately see that Bernanke was telegraphing additional purchases. The reaction was that Bernanke was “ready to provide additional accommodation as necessary.” Sounds familiar, right?
The same could be said for Operation Twist and the 2011 speech, where I believe Bernanke attempted to transfer near-term growth to longer-term growth by reducing the long-term borrowing costs of the United States in order to finance greater fiscal stimulus. By some estimates, the annual interest payments of the US have been reduced by $150 billion or more. The speech also focused on the longer-term fiscal sustainability and fiscal policy of the US.
I expect much of the same from Bernanke’s speech this year, with him stating that the US economy is still showing sluggish growth and that the Federal Reserve and the FOMC stand ready to provide accommodation.
I believe that Bernanke will not make any clear indication of whether or not the Fed will make additional purchases of Treasury securities and is not likely to announce any new purchases this year until the extension of Operation Twist expires at the end of the year. In previous FOMC releases over the past year, the Committee has stated that it is waiting to determine the efficacy of the new program. It is more likely that the Fed will explore new options to increase lending or nominal growth targets, such as unemployment, inflation, or GDP.
The biggest question I ask is: With corporate bond yields at record lows, Treasury yields at record lows, mortgage prepayment speeds at record highs, mortgage bond yields at record lows, and corporate default rates at record lows, what would additional purchases accomplish? Yes, in theory, these yields could continue to make record lows. But if the goal of QE is to push investors out of safe assets and into more risky, longer-duration assets, then there aren’t that many alternatives left.
I do not think that the Fed will extend its rate guidance out to 2015, as has been previously expected. The Federal Reserve governors only make economic forecasts out to two years, which is why the low rate guidance has been set to that range. However, one paragraph from the most recent FOMC may suggest a change to this (emphasis mine):
Many members expressed support for extending the Committee’s forward guidance, but they agreed to defer a decision on this matter until the September meeting in order to consider such an adjustment in the context of updates to participants’ individual economic projections and the Committee’s further consideration of its policy options.
So the FOMC may be exploring economic projections further out? Seems a bit silly, as the accuracy of these three-year forecasts would be suspect.
There has also been speculation that the Fed may cut the IOER (interest on excess reserves) rate paid by banks. This would be an incentive for banks to increase their lending. However, in Bernanke’s 2010 speech, he said that the effect would likely be “relatively small,” and the side effects of disrupting money markets. The FOMC also noted in its August minutes that the potential cut would have adverse effects on money markets and that the ECB’s recent cut of the deposit rate to 0 would allow the Fed to learn more about the potential consequences.
Lastly, there is a wide-ranging belief that the next round of asset purchases will be in the MBS sector. I’d note that in his 2010 speech, Bernanke highlighted “the FOMC’s longer-term objective of a portfolio made up principally of Treasury securities.” The Fed currently holds $1.25 trillion in MBS, which is about 16% of the market.
How Is the Market Positioned?
The Treasury market is currently positioned very long into the FOMC decision. The last three major policy announcements have marked a near or intermediate-term low for rates. However, I have to wonder, given the current duration of the Fed’s portfolio, could it afford a significant jump in rates?
As of the most recent Commitment of Traders (COT ) report, non-commercial accounts (speculators) are at one of their highest positions long in 10-Year Treasury futures (TY1). The last time it was this high? Yep, you guessed it: QE2. The most recent JPMorgan Treasury Client Survey showed “shorts” at their lowest point since the week of September 26 (Operation Twist) and “neutrals” at their highest point since the same week.
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Speculators also remain at their longest ever in the ultra-long bond contracts (WN1) and the long bond contracts (US1), but this has been a steady case for much of the past year.
At the same time, primary dealers are reducing their holdings of 6 to 11-year and 11-year+ Treasuries, which has not always been the case during prior QE announcements. You can see it in the two charts below.
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Many sell-side strategists have trumpeted any recent negative data point as indications that “QE3 is on the way.” While I respect that there is merit to the idea that QE3 could be coming soon, I think the almost one-directional rhetoric is concerning. It is almost as if Bernanke said, “Jump,” and the market responded by asking, “How high?” However, I’d note that some of these strategists have scaled back their calls for QE3 in the past week.
For further perspective, I looked into how 10-year yields have behaved from August 1 to the end of the year. Over the past 11 election years, rates have risen only three out of 11 years, with the average move resulting in a decline of 33 basis points. As a whole, rates usually decline during the fall and winter months, on average more than 65% of the time.
Lastly, I believe that the market should be focusing on what is really important here; Europe and Draghi. In nearly every earnings report and earnings call I read through this quarter, the company and its executives noted slowdowns due to the European crisis and macro uncertainties.
Also, I think that global central banks and the Federal Reserve are largely reactive to crises, not proactive. I think that if the Fed chooses to act, it won’t be in a way that the market has expected.
No positions in stocks mentioned.
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