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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.

In September, with the advent of QE III in the form of MBS purchases, we saw the balance sheet neutral inspired flattening reverse back to a steepening bias. Leading up to the March 13 FOMC meeting various Fed governors had been discussing the prospects of tapering asset purchases, and during the press conference Chairman Bernanke was hit with questions about what conditions would constitute a QE exit and when that might happen. Since then the QE III-induced steepening has begun to subside, and after a weak start to April, the 5-year/10-year curve has seen a dramatic flattening in a very short period of time.

Five-Year/10-Year Historical

Due to the unprecedented nature of this easing cycle the curve remains historically very steep. At 100bps the 5-year/10-year spread still rivals record steepness in previous cycles and is 70bps wider than the average spread going back 50 years. If the FOMC decides to taper purchases, the reduction in accommodation should lower the inflation premium and lead to curve flattening. When they do finally decide to exit, as in previous cycles the curve will likely have already reflected the tightening cycle by flattening from the front end. Net/net aside from a surge in the size of the Fed's balance sheet, which seems to be off the table, the future bias of the curve should be flattening.

Say what you want about the Fed's influence on the long end of the curve, but for all intents and purposes the 5-year is free to trade. As in every tightening cycle before, I believe if the 5-year were seeing symptoms of growth or an increase in the demand for money, the yield would begin to rise. Thus far, despite a more optimistic outlook and a breakout in stock prices, there has been no response that suggests the demand for money is increasing.

The consensus wants to be short the long end of the curve when the Fed tapers or exits altogether because that is where the purchases have been focused. However the yield curve is responding more to the level of accommodation and any reduction should produce a flattening bias and a headwind for the shorts.

Twitter: @exantefactor
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