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Michael Gayed: Fed Taper Be Damned, Says Bond Market


Bonds are sending some troubling messages as longer-duration bonds laugh at the taper -- and outperform.

All things truly wicked start from innocence.
-- Ernest Hemingway

One of the most overhyped theories out there is the notion that as the Federal Reserve tapers its bond purchases and attempts to exit the bond market, yields have nowhere to go but up. The belief centers on the idea that the Federal Reserve "controls" the bond market, and that once it is no longer in it, a vacuum will result. The problem with this idea, however, is that it assumes inflation, growth, and that the market won't replace the Fed's buying. We learned last year that the Fed has considerably less power over interest rates than we think given the yield spike of May-June.

Why is it so crazy to think that the yield curve could narrow and that yields could fall given still lackluster inflation expectations? Why is it impossible to think we can't re-enter a negative real rate environment? Sure, yields may rise if reflation hope is what drives it, but weak payroll data is a humble reminder that maybe, just maybe, we aren't at escape velocity just yet. The Fed may be on the path to stimulus reduction, but that may be more because of ineffectiveness rather than due to an improving economic growth trajectory.

Meanwhile, despite the taper, the yield curve is compressing. Take a look below at the price ratio of the iShares Treasury Bond 20+ Year ETF (NYSEARCA:TLT) relative to the iShares Treasury Bond 7-10 Year ETF (NYSEARCA:IEF). As a reminder, a rising price ratio means the numerator/TLT is outperforming (up more/down less) the denominator/IEF.

The Fed has pulled back some of its buying of longer-duration bonds, yet longer-duration bonds are getting a comparatively stronger bid. What gives? Note that strength began to take hold mid-November 2013, before the December taper, and has only been strengthening since. Could we be re-entering a risk-off period as a result, given that longer-duration bonds seem to be a good indicator of underlying risk sentiment? Maybe – seasonality does still favor equities, but it is worth watching the relative difference between Treasury bonds of varying duration to see if something wicked this way comes…

See also:

Did Federal Reserve Just Admit QE Mistake Was Deflationary?
Why This Economy Is More Sensitive to Interest Rates Than You Think

Why Job Numbers, Fed Moves Should Mean Little to Most Investors
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