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Contrary to Consensus: Why Tapering QE Is Bullish for Treasuries


The bond market doesn't wait on the Fed to tell it when it's time to ease or tighten.

This week's release of the March 20 FOMC minutes has put the QE tapering and exit talk front and center, and despite the weakening economic data of late, bond investors are analyzing how to position for the eventual reduction in accommodation. With stocks going parabolic to new highs into decelerating growth, at this point it seems the Fed is more concerned with excessive risk-taking behavior. This sentiment has been echoed in recent Fed governor speeches and even implied by rhetoric in the dovish wing of the Fed. In Wednesday's FOMC minutes the committee put forth their "Review of Efficacy and Costs of Asset Purchases" whereby they laid out some of the concerns being raised about the risks of continued QE:

Asset purchases were seen by some as having a potential to contribute to imbalances in financial markets and asset prices, which could undermine financial stability over time. Moreover, to the extent that asset purchases push down longer-term interest rates, they potentially expose financial markets to a rapid rise in those rates in the future, which could impose significant losses on some investors and intermediaries.

Various Fed speakers have communicated their intentions on how to calibrate QE purchases ever since QE III began late last year. I think there is a consensus developing that QE should respond to incoming data, tapering as data improves and increasing as data weakens. In my view this type of data-dependent response exposes the fundamental flaw in that monetary policy is by nature always behind the curve.

To put this in perspective let's review how their assessment of conditions has changed since the Fed first introduced a "quantitative" timetable for zero interest rate policy in 2011. In August in the midst of a stock market meltdown the Fed decided to remove the "exceptionally low rates for a long period" language and instead stick a date of "mid-2013" on the 0% Fed funds rate guidance. Just a few months later in January they would move the goal posts out a bit more into 2014. In September they said they would move the 0% date yet again to 2015 and re-institute QE by buying MBS. Still not satisfied in December they dropped the date guidance in favor of "qualitative" guidance for the unemployment rate of 6.5% and added US Treasuries to the QE III program. Three months later in March of this year with a negligible change in economic performance many members have concluded that its time to cut back.

Today this ex post monetary policy is even more problematic because the Fed believes they have successfully manipulated interest rates and therefore eliminated the discount mechanism embedded in the yield curve. They have trapped themselves into relying on lagging and extremely volatile data in order to gauge the economic trend. This will no doubt lead them to be constantly chasing their tail in what equates to a monetary policy quagmire.

Despite the Fed's helpless reliance on ex post analysis I believe the bond market still provides an effective ex ante discount if you know how to properly interpret the dynamics imbedded in the curve. The slope of the yield curve is a discount of the bond market's assessment of whether money is too loose (steep curve = wide inflation premium) or too tight (flat curve = narrow inflation premium). The outright nominal level of interest rates is not nearly as important as the inflation discount manifested in the relative level of interest rates.

When the demand for money is increasing (decreasing) you start to see the front end of the curve discount this activity by raising (lowering) short term rates and flattening (steepening) the curve. The bond market doesn't wait on the Fed to tell it when it's time to ease or tighten. The last three monetary cycles of the past decade illustrate this dynamic.

Five-Year Vs. Fed Funds

2001-2003 Easing Cycle

In May 2000 as Alan Greenspan was trying to quell the tech bubble he hiked it one last time by 50bps to get the funds rate to 6.50% citing inflation as the primary risk. At that time the 5-year yield was 6.75% and the 5-year/10-year curve was inverted by 30bps, a classic signal that money was too tight. However it wouldn't last long as the 5-year yield dropped to 5.00% by year end with the 5-year/10-year spread steepening from -30bps to 30bps by year end. The Fed, finally realizing they were behind the curve, opted for an emergency inter-meeting 50bps cut on January 3, 2001 followed by another 50bps at the January 31 regularly scheduled meeting. By April of 2001, after slashing the funds rate by 200bps in four months, the Fed had finally caught up to the 5-year.

2004-2006 Tightening Cycle

Just as the Fed was putting the finishing touches on their historic easing campaign in 2003 the 5-year began discounting a pickup in demand. During the first quarter of 2003 the economy was still hemorrhaging jobs but the equity market was trying to dig out of the hole that had seen a 50% collapse in the S&P 500 (INDEXSP:.INX). Money was too easy and the 5-year started to respond as yields lifted over 100bps to 3.45% in a short 2-month period. By June 2004 the 5-year had moved to 4.00% as the Fed remained on hold with the funds rate at 1.00%. Greenspan finally got the memo that the bond market had sent months prior, and at the June 30, 2004 meeting, he raised the Fed funds rate by a mere 25bps to 1.25%. This "measured" tightening approach would persist for the entire tightening cycle, and finally, by the end of 2005, the Fed funds rate caught up to the 5-year yield at 4.25%. By that time the 5-year/10-year curve had flattened by 100bps to an even spread, suggesting money was now too tight.
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