This week’s release of the March 20 FOMC minutes has put the QE tapering and exit talk front and center, and despite the weakening economic data of late, bond investors are analyzing how to position for the eventual reduction in accommodation. With stocks going parabolic to new highs into decelerating growth, at this point it seems the Fed is more concerned with excessive risk-taking behavior. This sentiment has been echoed in recent Fed governor speeches and even implied by rhetoric in the dovish wing of the Fed. In Wednesday’s FOMC minutes the committee put forth their "Review of Efficacy and Costs of Asset Purchases" whereby they laid out some of the concerns being raised about the risks of continued QE:
Asset purchases were seen by some as having a potential to contribute to imbalances in financial markets and asset prices, which could undermine financial stability over time. Moreover, to the extent that asset purchases push down longer-term interest rates, they potentially expose financial markets to a rapid rise in those rates in the future, which could impose significant losses on some investors and intermediaries.
Various Fed speakers have communicated their intentions on how to calibrate QE purchases ever since QE III began late last year. I think there is a consensus developing that QE should respond to incoming data, tapering as data improves and increasing as data weakens. In my view this type of data-dependent response exposes the fundamental flaw in that monetary policy is by nature always behind the curve.
To put this in perspective let’s review how their assessment of conditions has changed since the Fed first introduced a “quantitative” timetable for zero interest rate policy in 2011. In August in the midst of a stock market meltdown the Fed decided to remove the “exceptionally low rates for a long period” language and instead stick a date of “mid-2013” on the 0% Fed funds rate guidance. Just a few months later in January they would move the goal posts out a bit more into 2014. In September they said they would move the 0% date yet again to 2015 and re-institute QE by buying MBS. Still not satisfied in December they dropped the date guidance in favor of “qualitative” guidance for the unemployment rate of 6.5% and added US Treasuries to the QE III program. Three months later
in March of this year with a negligible change in economic performance many members have concluded that its time to cut back.
Today this ex post monetary policy is even more problematic because the Fed believes they have successfully manipulated interest rates and therefore eliminated the discount mechanism embedded in the yield curve. They have trapped themselves into relying on lagging and extremely volatile data in order to gauge the economic trend. This will no doubt lead them to be constantly chasing their tail in what equates to a monetary policy quagmire.
Despite the Fed’s helpless reliance on ex post analysis I believe the bond market still provides an effective ex ante discount if you know how to properly interpret the dynamics imbedded in the curve. The slope of the yield curve is a discount of the bond market’s assessment of whether money is too loose (steep curve = wide inflation premium) or too tight (flat curve = narrow inflation premium). The outright nominal level of interest rates is not nearly as important as the inflation discount manifested in the relative level of interest rates.
When the demand for money is increasing (decreasing) you start to see the front end of the curve discount this activity by raising (lowering) short term rates and flattening (steepening) the curve. The bond market doesn’t wait on the Fed to tell it when it's time to ease or tighten. The last three monetary cycles of the past decade illustrate this dynamic.
Five-Year Vs. Fed Funds
2001-2003 Easing Cycle
In May 2000 as Alan Greenspan was trying to quell the tech bubble he hiked it one last time by 50bps to get the funds rate to 6.50% citing inflation as the primary risk. At that time the 5-year yield was 6.75% and the 5-year/10-year curve was inverted by 30bps, a classic signal that money was too tight. However it wouldn’t last long as the 5-year yield dropped to 5.00% by year end with the 5-year/10-year spread steepening from -30bps to 30bps by year end. The Fed, finally realizing they were behind the curve, opted for an emergency inter-meeting 50bps cut on January 3, 2001 followed by another 50bps at the January 31 regularly scheduled meeting. By April of 2001, after slashing the funds rate by 200bps in four months, the Fed had finally caught up to the 5-year.
2004-2006 Tightening Cycle
Just as the Fed was putting the finishing touches on their historic easing campaign in 2003 the 5-year began discounting a pickup in demand. During the first quarter of 2003 the economy was still hemorrhaging jobs but the equity market was trying to dig out of the hole that had seen a 50% collapse in the S&P 500
(INDEXSP:.INX). Money was too easy and the 5-year started to respond as yields lifted over 100bps to 3.45% in a short 2-month period. By June 2004 the 5-year had moved to 4.00% as the Fed remained on hold with the funds rate at 1.00%. Greenspan finally got the memo that the bond market had sent months prior, and at the June 30, 2004 meeting, he raised the Fed funds rate by a mere 25bps to 1.25%. This “measured” tightening approach would persist for the entire tightening cycle, and finally, by the end of 2005, the Fed funds rate caught up to the 5-year yield at 4.25%. By that time the 5-year/10-year curve had flattened by 100bps to an even spread, suggesting money was now too tight. It Wasn’t Different This Time
Despite the message of the flat yield curve cycle, when Ben Bernanke takes over in January 2006, no doubt fighting his “Helicopter Ben” reputation, he cites inflation as primary risk and takes the Fed funds rate up another 100bps to 5.25% with the 5-year/10-year spread now inverting. Both Greenspan and Bernanke did their best to explain away the curve flattening while they were raising interest rates as a “conundrum” and “global savings glut” however ultimately their academic arrogance would lead to catastrophic consequences.
2007-Present Easing Cycle
In 2006 the real estate boom was still in full force, but underneath you could start to see indications that the momentum was waning. In January The Case-Shiller Home price index was growing at 15% YoY but by the end of the year that growth rate had plummeted to zero. In early July 2007 the 5-year was sitting right on top of 5.00% but credit market stress began to intensify and the yield began a precipitous drop towards 4.50% by the end of the month. The Fed was oblivious to the severity of what was unfolding and at their August 7 FOMC meeting decided to leave the funds rate at 5.25%, citing inflation as the “predominant policy concern.” Ten days later in a complete 180 the Fed cut the discount rate by 50bps. The 5-year was not waiting around and by early September at 4.00% over 100bps lower than just a month prior. The Fed finally started cutting the funds rate but the bond market was well ahead of policy. By the end of the year the 5-year was at 3.50% with the Fed funds rate at 4.25% and by the end of Q1 2008 after the demise of Bear Stearns the Fed funds rate had finally caught up to the 5-year yield at 2.25%.
I don’t know of any time in modern history where the Fed acted prior to the bond market discount. After the past three cycles why should you now expect this Fed, which has already proven their economic analysis is erratic, to correctly calibrate policy more effectively than the bond market? You shouldn't.
In December when the Fed dropped the “quantitative” date target in favor for a “qualitative” unemployment rate level target, this was a major pivot in this easing cycle because it reintroduced the market pricing mechanism that has been disregarded. With the zero interest rate date no longer driving policy the front end of the yield curve is now free to trade on discount. This is an extremely important development that has been overlooked by bond market participants.
In the context of how the bond market is going to react to a tapering of accommodation and the eventual exit from the easing cycle, I think we need to determine the answer to the following question: What has more influence on the yield curve, the weighted average duration of purchases or the credit created to finance those purchases?
Fed Balance Sheet Vs. 5-Year/10-Year
In this current easing cycle we have had the unique benefit of being able to observe two separate means of accommodation: a period where the Fed increased the size of their balance sheet and a period when the balance sheet stayed neutral. This is a critical distinction when assessing how the market will react to a reduction of stimulus.
During QE I when the Fed’s balance sheet exploded from $500 billion to $2 trillion the curve responded to heightened inflation risk by trading with a steepening bias pushing the 5-year/10-year spread 65bps wider. When QE I ended in March 2010 and the balance sheet flattened, so too did the curve. However during the Jackson Hole conference in August, Bernanke laid the foundation for another round of QE and the curve immediately responded to the inflation risk by steepening back out towards 140bps. By the end of the QE II program in June 2011 with the Fed’s balance sheet at a record size the 5-year/10-year spread was at record steepness near 150bps.
The massive QE II inflation premium in the market infiltrated the real economy and began to take its toll on the consumer. When the Fed opted to refrain from further QE in June of 2011 due to spiking inflation, the QE reflation trade began to unravel and in August the stock market crashed.
The Fed needed to get back in the game but without stoking inflation, so they opted for the balance sheet neutral policy dubbed Operation Twist whereby they would sell their short securities to finance the purchase in the long end of the curve. This would of course be intended on flattening the curve, but as you can see, the curve had already moved by 50bps before the program was even announced. The yield curve was responding to the end of balance sheet expansion, which was a de facto tightening. In September, with the advent of QE III in the form of MBS purchases, we saw the balance sheet neutral inspired flattening reverse back to a steepening bias. Leading up to the March 13 FOMC meeting various Fed governors had been discussing the prospects of tapering asset purchases, and during the press conference Chairman Bernanke was hit with questions about what conditions would constitute a QE exit and when that might happen. Since then the QE III-induced steepening has begun to subside, and after a weak start to April, the 5-year/10-year curve has seen a dramatic flattening in a very short period of time.
Due to the unprecedented nature of this easing cycle the curve remains historically very steep. At 100bps the 5-year/10-year spread still rivals record steepness in previous cycles and is 70bps wider than the average spread going back 50 years. If the FOMC decides to taper purchases, the reduction in accommodation should lower the inflation premium and lead to curve flattening. When they do finally decide to exit, as in previous cycles the curve will likely have already reflected the tightening cycle by flattening from the front end. Net/net aside from a surge in the size of the Fed’s balance sheet, which seems to be off the table, the future bias of the curve should be flattening.
Say what you want about the Fed’s influence on the long end of the curve, but for all intents and purposes the 5-year is free to trade. As in every tightening cycle before, I believe if the 5-year were seeing symptoms of growth or an increase in the demand for money, the yield would begin to rise. Thus far, despite a more optimistic outlook and a breakout in stock prices, there has been no response that suggests the demand for money is increasing.
The consensus wants to be short the long end of the curve when the Fed tapers or exits altogether because that is where the purchases have been focused. However the yield curve is responding more to the level of accommodation and any reduction should produce a flattening bias and a headwind for the shorts.