I realize that it’s still summer, but this bond market participant is suffering from severe irrelevant information sensory overload. I am beginning to wonder if anyone really knows what they are doing or how the market works anymore. It seems like people are completely lost and just making it up as they go along. The Fed has been fiddling with markets for so long that the market’s ecosystem has been compromised. The old rules of market discounts no longer apply, and nobody knows what the new rules are.
The obsession with tapering QE is beyond absurd and indicative of this policy saturation. The dealer community has been hypnotized by the duration of QE and can’t seem to break out of the trance. Treasury and mortgage-backed security (or MBS) yields are up 100bps across the curve, yet strategists are still trying to figure out how the Fed might calibrate purchases.
In case you have just joined us, the bond market doesn't care about how much the Fed is buying. Between Treasuries and MBSs, the daily average volume is over $800 billion. Who cares if the Fed cuts its $4 billion in daily purchases by $500 million? Dealers are splitting hairs over $5 billion to $10 billion per month of tapering in a market that trades $800 billion per day. It's irrelevant.
However, what's not
irrelevant is the policy chaos and the bond market’s response to the uncertainty.
Case in point: There was perhaps the most important market development last week that no one even noticed. On Monday, the spot rate on 12-month LIBOR fell to the lowest level of the cycle at 0.6646%. This was the same week that saw the Eurodollar futures curve for 3-month LIBOR blow out to historic steepness. This is not how it’s supposed to work. What is causing this mass divergence?
12-Month LIBOR Vs. Eurodollar Curve
As equity investors think in terms of price multiple, bond traders think in terms of spread. The term structure of the yield curve is the spread benchmark; typically these spreads have been a function of the bond market's inflation risk premium for the given term.
Bond investors will trade these spreads via butterflies (i.e. buying a 5-year and selling a 2-year and 10-year) and outright curve trades (i.e. buying 30-years and selling 10-years). Most of these trades are duration neutral, which is a way of taking out the directionality of the position, and are executed based on relative value.
5-Year/10-Year Vs. Eurodollar Curve
Currently, there are spreads across the interest rate complex that are at historically steep levels. In the Eurodollar curve, the spread between the 3-month LIBOR 4-year and 2-year futures is 216bps. Also in the belly of the Treasury curve, the spread between the 5-year and 10-year has steepened out to 125bps, near the widest levels in history, which were hit in June 2011 as inflation premiums peaked when QE2 was winding down. Bond market participants look at these spreads in the backdrop of benign inflation and know something isn’t right.
If there was demand for money, the spot rate on 12-month LIBOR would be rising; if the market was discounting Fed tightening, the curve should be flattening as rates rise. What we have here is a bear steepener, which is theoretically a product of rapidly rising inflation expectations.
Bear steepeners are extremely rare, and I would venture to guess there are not many bond market participants who have ever witnessed one, much less tried to trade it. What makes this bear steepener even more bizarre is that real yields (TIPS) are rising more than nominals, which is lowering inflation breakeven spreads across the curve. In the nominal curve, you have inflation premiums steepening, while in the real curve, they are flattening. This is curious divergence.
5-Year/10-Year Vs. 10-Year Breakeven Inflation
What I believe is happening is a rapid repricing of term structure risk premiums due to monetary policy chaos.
This curve steepening is a reflection of mass confusion among bond market participants. It is a function of a widespread reduction to interest rate risk that is irrespective of the discount of growth and inflation. One of the more glaring examples of this reduction in risk was the revelation that hedge fund titan Bridgewater blew out of its exposure to both nominal and real interest rates. As reported by Bloomberg:
Bridgewater, citing months of study, said it had underestimated the interest-rate sensitivity of various assets in its All Weather fund and was taking steps to mitigate the risk, according to clients who listened to or read a transcript of the June 24 call. By the end of the month, the Westport, Connecticut-based firm had sold off $37 billion of All Weather’s most rate-sensitive assets, Treasuries and inflation-linked bonds, according to fund documents and data provided by investors.
These guys are no dummies, and I would be willing to bet their models would have picked up on an increase in economic activity or rising inflation pressures that would have ordinarily been a catalyst for rising interest rates. The more likely explanation is that they got caught off guard by the Fed’s abrupt policy shift. The Fed's cost/benefit analysis (ex post QE) that was the catalyst for the decision to taper purchases may end up defining Bernanke’s tenure. The move from a 1.50% 10-year to what looks to be an inevitable 3.0% test in a 12-month time frame is having a profound impact on investor psyche and P&L. It’s a wonder if the Fed truly understood the systemic risk it was fostering by loading the market up with billions in extremely low (negative real) coupons.
What we do know now is that the Fed is finally admitting that the benefit of QE is questionable. This past week, the San Francisco Federal Reserve issued a report on the efficacy of QE. In this report, titled "How Stimulatory Are Large-Scale Asset Purchases?",
the researchers conclude:
Asset purchase programs like QE2 appear to have, at best, moderate effects on economic growth and inflation. Research suggests that the key reason these effects are limited is that bond market segmentation is small. Moreover, the magnitude of LSAP effects depends greatly on expectations for interest rate policy, but those effects are weaker and more uncertain than conventional interest rate policy. This suggests that communication about the beginning of federal funds rate increases will have stronger effects than guidance about the end of asset purchases.
Thanks, guys, you’ve been helpful... but there’s just one problem.
This past week, St. Louis Fed President James Bullard made one of the more interesting comments about the Fed’s record in economic forecasting. As reported by Bloomberg
Federal Reserve Bank of St. Louis President James Bullard, who has backed continued bond purchases by the Fed, said policy makers should be careful in changing course based solely on their economic forecasts, which have proven in the past to be too rosy.
Federal Open Market Committee forecasts “have tended to be too optimistic over the last several years,” Bullard, who votes on monetary policy this year, said today in the text of prepared slides for a speech in Paducah, Kentucky. “Given this experience, I think caution is warranted in taking policy action based on forecasts alone.”
When I saw this cross the tape, I was shocked at the revelation. With the Fed obviously ready to wind down QE, forward guidance of the Fed funds rate is the new Fed policy. This revelation begs the question I soon after tweeted
: "If the Fed thinks they don't forecast very well, then how can they set policy on forward guidance of the forecast?"
You wonder why the market is confused and there is no bid in the long end. Recall that, during the June bond market meltdown, Fed officials were quick to communicate to markets that participants were simply misinterpreting Fed policy. This is all just a big misunderstanding. I wasn't buying it. It doesn't matter what the Fed thinks; it only matters what the market thinks. As I said on July 1 in Bond Market's Memo to the Fed
Misunderstanding or not, the bond market has eliminated a lot of capital in a very short period of time. Leveraged long-term investors have been torched and capital deployment has been frozen. This unwind has been about a reduction in long-term capital and Bernanke’s insistence on vague threshold guidance for QE now make it virtually impossible to put this long-term capital back to work. How can an investor have confidence to buy a long-term bond? How can a bank have confidence to make a long-term loan? The answer is that the risk premium is going significantly higher. In the ensuing months, we will no doubt see this how this market adjustment evolves into an economic adjustment.
The untold story about this market episode is the damage on investor psyche. It will be very difficult to make a long-term capital allocation decision under this dark cloud of policy uncertainty. Regardless of whether the Fed holds off on tapering or extends guidance on zero percent interest rates, confidence has taken a big hit. That will destroy investment in long duration assets, banking system credit creation, and capital investment. That is something that we can all understand.
This is exactly what is happening. Add the uncertainty surrounding the appointment of a new Fed Chairman, and you have a delicate environment for market liquidity. The consensus sees rising yields as a reflection of an improved economy, a great rotation, or concerns about tapering. This is all false. The rise in interest rate risk premiums is an indictment of monetary policy chaos.
In the last 12 months, Fed policy has gone from balance sheet neutral to balance sheet expansion to tapering balance sheet expansion to forward guidance to a lame duck and to now the notion of Larry Summers, which is a completely unquantifiable risk factor. This policy whiplash is seeing the risk premium embedded in the term structure of the yield curve massively steepen. The bond trading environment has become one of sell first, bid last, and ask questions in March 2014 when the new Fed chairman takes the helm.