QE3 Has Been Priced Out of the Market... Now What?
A take on the tectonic shift that is going on in the bond market.
I don’t deserve special credit for this observation. Considering the historical correlation between the Fed funds rate and 5-year treasuries, the market's action is obvious.
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In every instance before a Fed tightening or easing cycle, the market has always moved first. That's because the Fed doesn't use forward-looking analysis to set monetary policy; it's always looking backwards. As such, I think any tapering of purchases by the Fed can be seen as de facto tightening. As the market becomes accustomed to a certain level of monetary purchases, it must reprice to that new level, up or down. Policy remains extremely easy, and tapering does not change that materially.
With that in mind, let’s take a look at what’s been going on in the Treasury Inflation Protected Securities (TIPS) market for the past month or so.
These securities are more sensitive to changes in commodity prices since they pay a constant rate of CPI inflation. This is commonly referred to as the “real yield.” So the longer the maturity, the further out the expectations of inflation are and the more volatile those expectations can be.
I frequently look at the 5-year and 10-year breakeven rates, which is the spread between the interest rate of the respective nominal Treasury and the interest rate of the respective TIP to get a sense of where long-term or short-term inflation expectations are headed. Over the past two and a half months, the 10-year breakeven inflation rate has declined from 2.58% to its current 2.02%. Even more spectacular are the movements since May 2, which is when yields bottomed out. Since May 2, the 10-year yield has risen by 59 basis points while the breakeven rate has tightened by 25bps, a feat that defies economic theory. In fact, the 10-year breakeven rate has erased all of its gains from QE3 and is taking out part of QE2.
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At the same time, there is an interesting mechanism at work within the curve. Up to this point, the 7-year and 10-year are now at their flattest points of the year versus the 30-year, with the 5-year close to that point. This should typically indicate that inflation expectations are getting taken out of the market, but it's also typical of a move before a Fed tightening, as the front end falls much faster than the long end, so that doesn't offer a clear picture. Lastly, the 2-year rate is held down by the amount of excess reserves (that artificially lower the Fed Funds rates through 0), which would point to the reasoning behind the steepest 2/10 curve in a few years.
Normally when Treasury yields rise, it's due to rising nominal growth expectations and a corresponding increased demand for money. Unfortunately, the underlying conditions in this instance of rising yields are exactly the opposite of what we've seen in the past. In this case, nominal GDP has slowed to a recessionary level of 3.4% year-over-year as of Q1 2013. (Not that nominal growth has been great in the last four years, but it’s headed in the wrong direction.) Additionally, year-over-year CPI growth declined to 1.1% in May from 1.7% a year ago and from a peak of 2.2% in October 2012. The “cleaner,” less volatile index of ex-food and energy costs is now at a 1.7% year-over-year rate after remaining relatively stable for the last two years.
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This is to be expected as personal consumption has declined to recessionary levels. The April reading of personal consumption only rose 2.8% year-over-year on a nominal basis and 2.1% on a real basis. The nominal figure is the lowest reading in the last 50 years, with the exception of September 2001 and the 2008 credit crisis. The consumption data does not paint a pretty picture going forward. I think that with tax returns getting pulled forward into January and mostly February, the lower income from higher payroll taxes is taking a toll on consumers, as evidenced by falling year-over-year consumption in March and April.
The end results offer a few takeaways. First, the market is not waiting for the Fed to taper and is already pricing out the $45 billion flow discount from Treasuries and the similar $40 billion discount from MBS. Additionally, we can assume that the market had been pricing in too large a premium over actual inflation since it was believed that the Fed would create runaway inflation. Thus, the belief was that investors should hide out in “real assets” that would protect them from rising inflation, such as gold and TIPS. Although we haven't seen any runaway inflation, if anything, excess money supply and a structural misallocation of capital are preventing any demand pull from occurring in the economy.
There is a positive aspect to all of this mess. The problem with a winding down of the Fed’s program is that -- unlike any other time in history -- investors' expectations are all over the map; people whom I have agreed with on a lot of market issues now have views that are extremely different from my own. Some think that for every $10 billion of 10-year equivalent flow, rates are depressed by 2-3bps (so about 15-20bps). Others think that without the flow, rates should be as high as 3% to 4%. To top it off, by centering all purchases in the long-end, the Fed has reduced the amount of supply available to experience normal market operations while the global supply of high-quality collateral is low and demand is rising due to Dodd-Frank and other global regulatory changes. So the repricing of forward expectations is volatile and will remain volatile.
I am of the belief that the recent data suggests the Fed could be even easier with its recent curriculum of inflation as a guideline, but the market seems to think that the Fed is going to change this inflation goal or accept defeat in not achieving it. I don’t personally think they should be buying at all, but I am trying to decipher what is going on and invest accordingly.
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