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Welcome to the Dark Side of QE: The Yield Curve Adjustment Process


The Bernanke disciples are claiming QE victory with stocks refusing to go down, however his metrics of growth and inflation are decelerating to near the lows of the recovery.

On Thursday the Treasury auctioned off the 30-year bond in what appeared to be strong buy-side demand. Indirect bidders who represent foreign central banks took down 39%, of which was above recent levels of recent foreign participation. As soon as the results hit the tape, the USDJPY started spiking on what appeared to be Japanese accounts swapping into dollars to finance their 30-year allocations. That yen-selling pushed USDJPY above the psychological 100 level which seemed to trigger some buy stops as the currency pair continued to rally quickly, hitting the 100.50 level.

USDJPY 2-Day Tick

The spike through 100 turned what was a strong auction rally in the long end of the curve into an immediate reversal sending yields higher by 5bps into the close. The reversal was swift and you started hearing chatter about cross currency structures that needed to sell Treasuries to hedge the yen weakness, but not much was made of it. Friday we woke to further weakness in bonds as the USDJPY continued higher sending the 10-year up 10bps from Thursday's low.

Apparently the culprit was a carry trade structured product called a Power Reverse Dual Currency Note whereby the issuing Japanese banks were forced to sell Treasuries against the weakening yen, and presumably the 100 level set off a wave of this hedging. So ironically, what was a strong Treasury auction from Japanese accounts triggered a massive sell-off in yen that triggered a massive sell-off in Treasuries.

US Bond Futures 5-Day Tick

Back on January 22, I wrote a piece about the ramifications of the Bank of Japan's new 2.0% inflation target and subsequent volatility it was causing in the FX markets. I posited whether this new monetary regime would trump the Fed's ability to affect US capital market pricing in Are We Witnessing a Tectonic Shift in Which Central Bank Dominates Asset Prices and Risk Premium?:

Today could be a seminal event as we may be witnessing a central bank transfer of power. The Federal Reserve's monetary policy has been dominating asset prices since the era of easy money began in 1998. We've now come full circle. With the introduction of a 2% inflation rate by the Bank of Japan and a subsequent effort to devalue the yen to get it there, we may be witnessing a tectonic shift in which central bank policy dominates asset prices and risk premiums.

The FX market is very deep and liquid. This kind of volatility is significant, and if it continues, it's only a matter of time until it finds its way into the US capital markets.... It's not US economic and earnings growth that will derail this rally in risk. Like in 2008 and in 1998, it's a systemic second or third derivative event that the market cannot discount.

Cue the Power Reverse Dual Currency Note. You can't make this stuff up. If you ever had any questions about whether the Fed had control of the US bond market, Friday was an eerie example of what can go wrong. What was even scarier about last week's FX and bond market volatility is that some esoteric foreign structured product that no one has ever heard of showed how fragile and susceptible the bond market has become.

You would think this type of bond market volatility that is completely driven by something the Fed can't control would scare the bejesus out of Ben Bernanke and his faithful disciples, but ironically this week with stocks rallying to new all-time highs and rumors of a Fed exit, they were instead taking a bit of a victory lap. It seems that because stocks won't go down that Bernanke's easy money policy has been vindicated. This sentiment was juxtaposed against anti-Bernanke comments out of prominent hedge fund managers during presentations at this past week's investor conferences.

Business Insider's Joe Weisenthal wrote a piece suggesting hedge fund managers don't understand monetary policy:

One big theme: Bernanke hate. A lot of the big guys HATE him.

If you listen to a lot of old industry veterans, you'll hear a lot of grousing about Bernanke and QE and all that jazz. Basically, they sound like your typical comments section on a blog.

Hedge funds are doing badly in this rising-tide-lifts-all-boats market, and they feel that they would be outperforming if the Fed just let things collapse, and they could swoop in when prices "clear."

Matthew O'Brien of the Atlantic followed up, defending Bernanke, suggesting that hedge funds are underperforming because they don't get Keynes.

The biggest mistake an investor can make today is not realizing it's Keynes' world, and we're all just living in it. Now, in normal times, there's a straightforward relationship between money and prices: the more of the former, the higher the latter. (Indeed, Keynes wrote about this before he invented Keynesian economics). But these aren't normal times -- interest rates are stuck at zero. When cash and bonds are close substitutes -- both yield nothing -- printing money won't increase inflation. It won't do anything.

This hedge fund ridicule misses the point. As I wrote in June last year in Trading the Wrong Playbook Bubble, hedge funds aren't underperforming because they don't get economics, it's because they are applying valuation models to a market that can't be valued:

By manipulating the yield curve to generate negative interest rates, Fed policy has taken the discount out of the discount rate and thus removed the ability for markets to correctly price assets. Fed policy has essentially turned all assets into commodities subject not to valuation but simply the supply and demand for the securities.

The by-product of this Fed policy has produced what I have characterized as the wrong playbook bubble.

At the same time that the Fed was taking the discount out of the discount rate, we saw an explosion of financial analysts, investment bankers, and so-called alpha-generating hedge fund managers all using the same playbook based on valuation models. So while the Fed was making valuation irrelevant, more and more investors were relying on and utilizing the same valuation models to make capital allocation decisions.

By explicitly trying to manipulate the yield curve the Fed has convinced market participants (hedge funds) that valuation is irrelevant. The 10-year yield is the benchmark pricing mechanism for every asset on the planet. The problem hedge fund managers have with QE is not that they don't like higher asset prices, it's that they don't know how to price assets.

Whether you believe the Fed has successfully manipulated the yield curve or not, just the fact that they are in the market means no one really knows where Treasuries should trade. For this reason we don't know where asset prices should trade. However it seems we are about to find out, and I think it is going to be a very uncomfortable process.

Friday, the Wall Street Journal resident Fed leaker Jon Hilsenrath broke the story that the Fed is mapping the strategy for the eventual QE exit. In what was basically a non-event report full of stuff we already know, one little tidbit stood out to me (emphasis mine):

Officials are focusing on clarifying the strategy so markets don't overreact about their next moves. For example, officials want to avoid creating expectations that their retreat will be a steady, uniform process like their approach from 2003 to 2006, when they raised short-term interest rates in a series of quarter-percentage-point increments over 17 straight policy meetings.

I don't know what's worse, that participants are surprised the Fed has an exit strategy, or that the Fed felt compelled to leak the fact that they have an exit strategy. Regardless, if the Fed and the Keynesian intellectuals who worship at their feet believe Bernanke can simply wield a wand and calmly move the bond market back to fair value, they are being extremely naïve.

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.

According to ICI statistics, since 2008 mutual funds have seen an aggregate $1 trillion of inflows and of that domestic equity funds have seen net outflows of $380 billion and taxable bond funds have seen net inflows of $1 trillion. Since the 10-year yield first hit 2.0% in September 2011 taxable bond funds have seen inflows of $370 billion while domestic equity funds have seen outflows of $200 billion. Clearly the retail investor has increased exposure to credit, and arguably the so-called asset price wealth effect generated by QE is now just as reliant on bond prices as stock prices.

It's not just taxable bond funds that are vulnerable to the adjustment process. Since the 10-year hit 2.0%, multiple expansion has been responsible for over half of the market's 45% gain. I think most media pundits and even many market participants assume that QE is benefitting stocks directly, but as I have written, I think this confuses correlation with causation. QE benefits the equity market only to the extent that it benefits the bond market, and more importantly, credit risk premiums. As I wrote last week in the Low Spark of High Yield Boys, Redux, the high yield market has actually been leading this rally in multiples:

The casual market observer would look at the parabolic move in the S&P 500 (INDEXSP:.INX) and assume stocks have led the rally in risk, and from a price-percentage-gain perspective, they have outperformed HY bonds. However from a risk premium/multiple perspective HY has massively outperformed stocks, suggesting the rally in stocks is actually a function of multiple expansion on the back of HY credit risk premium tightening. This revelation has important consequences going forward because of where credit sits at this stage in the cycle both on a relative basis and in outright yield.

I don't think equity investors appreciate how the market will go about re-pricing from a 2.0% to fair value. It might be 2.0% or 4.0% or somewhere in between. We can make some assumptions based on historical relationships to consumption growth and inflation, but nevertheless, the market is not likely to take a smooth trip to get there and the price swings could be significant. Just taking today's 10-year to 3.5% would result in a 15% haircut on existing coupons. And with benchmark interest rate volatility sure to rise, you should expect volatility in higher beta credit and equity risk premiums to also rise.

Don't kid yourself: This rally in stocks has been a function of multiple expansion based on a collapse in credit risk due to a depressed 10-year yield. If the Fed is truly mapping the exit that game is coming to an end. In a rising rate environment, earnings growth should shoulder more of the returns going forward, and in a sub 4.0% nominal GDP world, earnings growth is going to be hard to come by. According to FactSet, Q1 earnings growth has been 3.2% which is in line with Q1 nominal GDP growth of 3.4%. The Bernanke disciples are claiming QE victory with stocks refusing to go down, however his metrics of growth and inflation are decelerating to near the lows of the recovery.

I think the Fed is looking to back off QE because of how asset markets are behaving, not because the economy is on a more sustainable path. In so doing they are risking a very disruptive adjustment process removing multiple support, which has been a key catalyst in market performance, at a time when earnings growth is decelerating. Throw in the fact that the market is loaded with low long duration coupons and I think he's playing a very dangerous game in what should prove to be a potentially very volatile environment.

Welcome to the dark side of QE.

Twitter: @exantefactor

Also see:
Taper Talk: A Serious Look at the Fed's Options

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