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The Critical Connection Between Confidence in the Federal Reserve and US Interest Rates

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Remember, mood drives changes in laws, not the other way around.

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In the world of finance, few things matter more than the narrative. Stories frame why investors are buying or selling a particular security. Stories drive price and the perceptions of value. In real time, stories justify actions.

Until quantitative easing, the story in the US Treasury market was that inflation expectations drove US Treasury yields. Moreover, bonds were cheap or expensive when expectations and prices diverged too much.

Over the past three years, the story for Treasury yields has shifted from inflation expectations to the expectations of the Federal Reserve. First, the story was how many Treasury bonds the Fed would buy. Then the story was whether the Fed would buy or not buy additional securities. Over the past year, though, even that story has changed as the expectations of the Federal Reserve have shifted from "if" to "when" the purchases will end. The Treasury story today might best be called "The Taper Caper" -- a guessing game of end dates.

But I'd offer that even the "taper" story today is not fully embraced by all Treasury bond buyers. Some financial pundits are now suggesting that while the end of QE is contributing to the rise in rates, what is really pushing bond prices lower is economic expansion and the inevitable rise in inflation.

Stories drive price.

While the justifications described above are interesting to me, I am afraid that not only do they reflect misguided perceptions of cause and effect, but they are also completely missing the most obvious and profound story for Treasuries today: Demand has peaked. And at the risk of over-extrapolation, let me be even more encompassing: Demand for fixed income overall has peaked.



As I have offered before, in investing, peak demand occurs at the peak price. Investors want more of a security as prices rise. This having been shown to be true over time, the story becomes more and more compelling as prices increase. And at the top, even the most strident holdouts capitulate and join the buying frenzy, with retail investors inevitably the last to succumb to the Sirens' song.

So if the demand for bonds has truly peaked, let me offer the five threads, which, when woven together, created the most compelling story for US fixed income in history.

The perception of increasing competence/strength of the Fed – In September 1981, in the same week that 10-year US Treasury rates peaked, newly appointed Fed Chairman Paul Volcker told Congress, "Americans have not seen for many years a successful fight on inflation, or balanced budgets, or so massive a tax reduction. A lot of bets on the future are still being hedged against the possibility that you, and we, will not carry through."

Talk about a statement on public confidence (or the lack thereof) in the Fed and Washington in general! Investors were openly betting against the Federal Reserve and Volcker knew it. But please consider where we were just thirteen months ago. Not only were bond investors certain of what the Fed would do and its effectiveness, but there was also no hedge against the possibility that the Fed would not follow through . In fact, bond investors were front-running the Fed. Rates bottomed two months before Chairman Bernanke's "to infinity and beyond" Buzz Lightyear moment.

While it clearly wasn't a straight path from 1981's underconfidence to last summer's overconfidence, I can't emphasize enough the role that increasing faith in the Federal Reserve has played in the 31-year decline in long-term US interest rates. (Moreover, I hope that the correlation between rising long-term rates and declining confidence in the Federal Reserve over the past thirteen months is clear. The public's perception of Board of Governors' unity and the clarity and consistency of the Fed's message have both declined as rates have risen.)

But please appreciate all of the various ways that the low interest rate consequences of high confidence in the Federal Reserve have rippled through the economy. From higher corporate profit margins, to lower bank deposit costs, to cheaper hedging costs of everything from foreign exchange to commodities, the Fed "confidence effect" has been staggering. And then there is the whole cascade of economic benefits that arise from the public's perception of "managed" low long-term inflation rates and the Fed "put" on asset prices. For our overleveraged, financialized economy, I'd offer that confidence in the Federal Reserve may be the least appreciated economic variable out there.

Just pause for a moment to think about what buyers of 10-year US Treasuries yielding 1.40% last summer must have been assuming about the long-term stability of our economy and financial system and the omnipotence of the Federal Reserve!
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Position in SH and JPM.
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