Going into last week’s FOMC meeting, I tried to get readers to focus on two main themes: That the tapering of asset purchases had largely been discounted by the long end of the curve and that the risk was that with the commencement of tapering, the market would begin to look towards discounting rising short-term interest rates.
On December 10 in Bond Market Trading is Already Discounting the Fed Tapering
, I said the following:
I’m not saying the bond market isn’t susceptible to rising rates and increased volatility as the Fed exits its unconventional polices; however, from where I’m sitting, the long end of the curve is well-prepared and much closer to fair value than many presume. Most of the embedded volatility in the bond market is buried in the negative convexity of MBS, and with that volatility reduced, so too is the risk of a violent move towards higher yields.
And here's a snippet from my December 16 column, The Markets Are Not Ready for a Rise in Short-Term Interest Rates.
As the Fed removes stimulus, inflation premiums are going to fall, the yield curve is going to flatten, and the dollar is going to strengthen. While everyone is sitting in the front end of the curve waiting on the tapering impact on the long end, the volatility could be in short rates. Conceivably, tapering is already discounted in long-term interest rates and most of the Fed action is going to be shifting from long end to front end. And it’s the front that is more mispriced than the back.
This is not what we are told by Wall Street’s interest rate strategists. For the past six months, all we have heard about was whether and when tapering would ensue, though no one would tell you what the estimates meant. Why? Because they only know how to tell you what the Fed is doing rather than what the market is discounting.
Wednesday, the Fed announced it was going to taper purchases by $5 billion treasuries and $5 billion mortgages per month. It also lowered the unemployment rate threshold for raising the funds rate. The market responded as many expected with the long end of the curve and mortgages under pressure while short rates (2015) in the eurodollar “money” curve for 90-day LIBOR futures fell.
After the close on Wednesday, Minyanville’s Michael Sedacca hosted a webinar with myself and bond market guru Kevin Ferry to discuss the Fed decision and prospects for how the yield curve would behave in 2014 under the removal of stimulus. Kevin’s prescient analysis focused on the battle in the market between participants who position for forward guidance and participants who position for rising rates, and where that battle takes place on the curve. His message to listeners was to look for market volatility in the belly of the eurodollar and treasury yield curve as rate hike discounts look to fade the Fed’s forward guidance of when these rate hikes will occur.
To illustrate this interplay between the market and the Fed’s intentions, I posted a chart of the Fed funds rate over the five-year yield during the last tightening cycle. When Greenspan finally took Fed funds to 1% in 2003 and left it there for a year, the economy was already beginning to recover. The five-year began to discount this acceleration, rising well in advance of the first rate hike. When Greenspan initiated his own version of forward guidance in the form of “measured” rate hikes, the five-year was already at 4%, as the economic growth rate was peaking, which arguably was the market’s perceived destination for Fed funds.
Thursday morning, I walked in to see that the belly was under significant pressure with the long bond outperforming the rest of the curve. I tweeted
out, “Well what do you know… belly is getting crushed…” cc’ing Kevin and Michael. The market was trading exactly how we thought. The market was immediately moving beyond the tapering discount in the long end and onto normalization in the front end. This trend continued on Friday in what proved to be a massive flattening of the long end, with the 30-year up over a point while the five-year was weakening. The five-year/ 30-year spread flattened 20bps on the week with the five-year yield up 16bps since Wednesday.
Wall Street market strategists like to spend this time of the year telling you where they think the 10-year yield and S&P 500
(INDEXSP:.INX) are going to be as the year closes. Not only is this a ridiculous exercise, it’s not even relevant. It’s not where we are going that is as important as how we get there and under what conditions. Whether the 10-year is at 3.0% or 4.0% or somewhere in between is not nearly as important as whether the slope of the curve flattens or steepens.
The most important market discount is the inflation premium, and this gets manifested in the slope of the yield curve. Under zero interest rate policy and QE, the curve has been the steepest in history as investors have commanded extreme compensation to hold duration. As the Fed removes this record amount of stimulus, the market is going to reduce this inflation premium and the curve is going flatten. As such, the long end of the curve, which has dominated volatility, is going to be at the mercy of the front end of the curve, as it unlocks from zero interest rate policy.
This is going to be Janet Yellen’s biggest challenge and could define her first year at the helm of the Fed. Just like prior to the previous tightening cycle, the market is going to want to take the five-year to where it thinks it belongs long before the Fed is ready for it to get there. This is going to impact forward rates and the cost of dollar term financing. Thus the Fed, with a move towards forward guidance, is going to try to anchor forward rates to zero. This push-pull battle is going to be in play at every economic data release, during every Fed speech, and at every FOMC meeting. This was the message from our webinar, and this was the message of the market in Thursday and Friday’s price action.
Most market participants only know two Fed chairs: Greenspan and Bernanke. As I said during the webinar when asked about Janet Yellen’s tenure, I think the thing to look out for is how the market tests her monetary moxie. Greenspan entered in 1986 and was tested with the 1987 stock market crash. Bernanke entered in 2006 and was tested with the 2007 credit crisis. What will be Yellen’s test?
This time last year in A 2013 Bond Market Prognostication
, I issued a forecast for a big breakout in long-term interest rates. The long bond had closed out 2012 at the same level it had closed out 2011, and I thought there was a big false sense of security by participants that the Fed’s purchases were able to hold bond yields in line. From a technical perspective, the US bond futures contract had been confined to a definable channel and there was a risk that if that channel was violated, the market would be under significant downside pressure.
No doubt there was tension in the long end of the curve coming into this year. The market was full of low-coupon, negatively convex, long-duration assets that were a powder keg on leveraged balance sheets. A blow-up was only a matter of timing. However, coming into 2014 the market has flip-flopped. The negative convexity has largely been flushed out of the long end of the curve and has transferred into the front via the eurodollar futures strip. Forward guidance has drawn the line in the 2015 part of the curve, and the battle will be waged there. In September and December 2015 eurodollar futures alone, open interest represented $2 trillion in notional positions, so we know some large bets have been placed.
One side is betting with the Fed’s ability to fix US dollar pricing, and the other side is betting on the market’s ability to unfix. As Kevin aptly put it during the webinar, the risk is that things will get better sooner than the Fed anticipates. Regardless, the bias in 2014 is for the curve to anticipate the Fed’s eventual exit. This should force the front end higher and flatter while making forward guidance an exercise in futility.