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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.

It Wasn't Different This Time

Despite the message of the flat yield curve cycle, when Ben Bernanke takes over in January 2006, no doubt fighting his "Helicopter Ben" reputation, he cites inflation as primary risk and takes the Fed funds rate up another 100bps to 5.25% with the 5-year/10-year spread now inverting. Both Greenspan and Bernanke did their best to explain away the curve flattening while they were raising interest rates as a "conundrum" and "global savings glut" however ultimately their academic arrogance would lead to catastrophic consequences.

2007-Present Easing Cycle

In 2006 the real estate boom was still in full force, but underneath you could start to see indications that the momentum was waning. In January The Case-Shiller Home price index was growing at 15% YoY but by the end of the year that growth rate had plummeted to zero. In early July 2007 the 5-year was sitting right on top of 5.00% but credit market stress began to intensify and the yield began a precipitous drop towards 4.50% by the end of the month. The Fed was oblivious to the severity of what was unfolding and at their August 7 FOMC meeting decided to leave the funds rate at 5.25%, citing inflation as the "predominant policy concern." Ten days later in a complete 180 the Fed cut the discount rate by 50bps. The 5-year was not waiting around and by early September at 4.00% over 100bps lower than just a month prior. The Fed finally started cutting the funds rate but the bond market was well ahead of policy. By the end of the year the 5-year was at 3.50% with the Fed funds rate at 4.25% and by the end of Q1 2008 after the demise of Bear Stearns the Fed funds rate had finally caught up to the 5-year yield at 2.25%.

I don't know of any time in modern history where the Fed acted prior to the bond market discount. After the past three cycles why should you now expect this Fed, which has already proven their economic analysis is erratic, to correctly calibrate policy more effectively than the bond market? You shouldn't.

In December when the Fed dropped the "quantitative" date target in favor for a "qualitative" unemployment rate level target, this was a major pivot in this easing cycle because it reintroduced the market pricing mechanism that has been disregarded. With the zero interest rate date no longer driving policy the front end of the yield curve is now free to trade on discount. This is an extremely important development that has been overlooked by bond market participants.

In the context of how the bond market is going to react to a tapering of accommodation and the eventual exit from the easing cycle, I think we need to determine the answer to the following question: What has more influence on the yield curve, the weighted average duration of purchases or the credit created to finance those purchases?

Fed Balance Sheet Vs. 5-Year/10-Year

In this current easing cycle we have had the unique benefit of being able to observe two separate means of accommodation: a period where the Fed increased the size of their balance sheet and a period when the balance sheet stayed neutral. This is a critical distinction when assessing how the market will react to a reduction of stimulus.

During QE I when the Fed's balance sheet exploded from $500 billion to $2 trillion the curve responded to heightened inflation risk by trading with a steepening bias pushing the 5-year/10-year spread 65bps wider. When QE I ended in March 2010 and the balance sheet flattened, so too did the curve. However during the Jackson Hole conference in August, Bernanke laid the foundation for another round of QE and the curve immediately responded to the inflation risk by steepening back out towards 140bps. By the end of the QE II program in June 2011 with the Fed's balance sheet at a record size the 5-year/10-year spread was at record steepness near 150bps.

The massive QE II inflation premium in the market infiltrated the real economy and began to take its toll on the consumer. When the Fed opted to refrain from further QE in June of 2011 due to spiking inflation, the QE reflation trade began to unravel and in August the stock market crashed.

The Fed needed to get back in the game but without stoking inflation, so they opted for the balance sheet neutral policy dubbed Operation Twist whereby they would sell their short securities to finance the purchase in the long end of the curve. This would of course be intended on flattening the curve, but as you can see, the curve had already moved by 50bps before the program was even announced. The yield curve was responding to the end of balance sheet expansion, which was a de facto tightening.
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