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Bernanke's New Dance Is Called 'The Tighten Up'


In actuality, the only thing that matters is whether or not the bond market is tightening.

On the front page of this weekend's Wall Street Journal, the article reporting on the employment report was titled, Jobs Rise Enough to Soothe Markets. I thought to myself, they must not be talking about the bond market because it was anything but soothed.

Turning the page I found Jon Hilsenrath's weekly Fed article that had been posted during Friday's trading session. These late Friday Fed leaks from Hilsenrath are becoming all too common. Apparently the Fed wants to make sure we understand what they aren't telling us about what they don' t know. What would market participants do without the service of Hilsenrath? (Emphasis mine.)

Federal Reserve officials are likely to signal at their June policy meeting that they are on track to begin pulling back their $85-billion-a-month bond-buying program later this year, as long as the economy doesn't disappoint.

A good-but-not-great jobs report Friday ensured officials wouldn't want to act right away and would instead want to see more data before taking a delicate step toward winding down the program.

Many Fed officials believe the job market and the broader economy have made enough progress to warrant considering a partial pullback in their bond buying, but they still have reservations about the outlook that give them pause.

Officials believe the private sector, aided by a rebounding housing market and solid consumer spending, has enough momentum to drive a pickup in growth later in the year.

But officials run the risk of errors in their forecasts. In every year of the recovery, officials have expected the economy to grow faster than it did.

Who are these "officials" Hilsenrath is citing? Let's not kid ourselves. This article reads more like a press release than monetary policy analysis and it was obviously a direct communication from Ben Bernanke.

This constant beating around the bush is getting really old, and I'm not sure how much patience the bond market has left. In fact, it's already taking matters into its own hands. This is one of the most important market developments that no one is talking about.

As I wrote in the Yield Curve Adjustment Process:

What I think gets lost in the discussion about the cost/benefit of QE, and more importantly, how long it has gone on, is the fact that there are billions of potentially very volatile long duration low coupons on the balance sheets of investment portfolios. Bond math dictates that for a given duration, the lower the coupon, the more volatile the price. A 2% 10-year is much more price-sensitive than a 4% 10-year. Due to the nature of these low, long duration coupons, the adjustment process is likely to be very chaotic, making last week look like a game of tiddlywinks. This is bound to have a profound impact on portfolios and on sentiment.

With QE "calling," all higher coupons from the market investors have had no choice but to reinvest into lower -- and in some cases, negative -- coupons. A modest normalization in real yields would result in a discounting of these coupons in effect trapping capital on leveraged balance sheets. Thus even a slight rise in yields could broadly tighten credit market conditions.

To find the market tightening you have to look no further than at the rise on real yields as reflected in TIPS (treasury inflation protected securities) yields. Since the cycle lows the yield on the 5-year and 10-year TIPS (Treasury Inflated Protected Securities) have risen 95bps and 90bps respectively. On Friday the 10-year TIPS yield traded just shy of zero after spending the past year in negative territory. Real yields rising is by definition tightening credit conditions.

Five-Year and 10-Year TIPS Vs. Nominal Yields

It's not just in the TIPS market where you see the bond market tightening. TIPS yields have pushed up nominal yields, which in turn ignited a convexity blowout in the MBSs market, unwinding the entire QE III compression and then some.

MBS Spread

The move in the MBS market has not only tightened conditions in the mortgage market where rates on 30-year conventional loans has surpassed the 4.0% threshold, but more importantly, it has also tightened conditions in the banking system where so many of these securities are held.

One of the primary targets of QE was bank balance sheets. The bond-buying program was aimed at reducing yields to a level where investable securities become uneconomical for banks to buy in order to redirect capital into credit creation.

From the June 20 2012 FOMC meeting press conference (emphasis mine):

JENNIFER LIBERTO. Jennifer Liberto, CNNMoney. Chairman, are you at all concerned that Operation Twist could affect banks' earnings and their willingness to lend? Does it undercut your ability to increase credit to consumers?

CHAIRMAN BERNANKE. Credit to consumers? No, I don't think so… I've heard the argument that by lowering interest rates, you make it unattractive to lend. I don't think that's quite right. What we're lowering is the safe interest rate, the Treasury rate. That should make it even more attractive for banks, rather than to hold securities, to look for borrowers and to earn the spread between the safe rate and what they can earn by lending to households and businesses.

So I think that macro policy and monetary policy can, in fact support lending…. But lower interest rates on securities and other types of assets, all else equal, would induce banks to look for higher-yielding returns, higher-yielding assets in the form of loans to household and businesses.

Has QE successfully induced banks to reduce securities position in favor of extending credit to households and businesses?
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