Friday, March 16, 2012

Is the bond market tightening for the Fed?

In my last post, I wrote about former Fed staffer Vincent Reinhart's in Barron's musing about Bernanke's lack of political capital to engage in quantitative easing after June, so another round of QE is likely in the cards at or before the June meeting. I had suggested that investors should carefully scrutinize the FOMC statement for hints of further easing, or statements about other "unconventional means" such as sterilized QE.

The verdict is in. The February FOMC statement tilted a little bit hawkish compared to the January statement. The Fed grudgingly allowed that growth was picking up:
The Committee expects moderate economic growth over coming quarters and consequently anticipates that the unemployment rate will decline gradually toward levels that the Committee judges to be consistent with its dual mandate.
...but left the door open for further easing because they did not see inflation to be a threat:
The recent increase in oil and gasoline prices will push up inflation temporarily, but the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate.
There was no mention of any discussion about other measures, such as sterilized QE. In effect, the Fed is in a wait and see mode, but signaled that it is prepared to stimulate should signs of weakness appear. However, it did also indicate that tightening is not around the corner.

Bond yields go on a tear
So what was the market reaction? In the wake of the FOMC announcement, Treasury yields spiked. Not only did 10-year yields rally through a critical technical resistance level, it breached a downtrend that began in April 2011.

In effect, the bond market is saying that an economic recovery appears to be self sustaining. Under these circumstances, bond yields should be rising as faster growth would raise inflationary expectations.

In the wake of the sudden rise in Treasury yields, the blogosphere has been full of stories about how the Chinese have either stopped or lessened their purchase of Treasury securities because of their falling current account surplus and need to import commodities, such as oil (see examples here and here). While that might a plausible longer term explanation, Chinese demand didn't change on a dime on Tuesday after the FOMC meeting. Market expectations did.

Here is the risk for the Bernanke Fed. The Fed has traditionally used the short end of the yield curve to inject or withdraw liquidity from the market. Now the Bernanke has began to use "unconventional" measures to intervene in the long end of the curve. There has been a lot of discussion and hand wringing at the Fed about why housing didn't respond well to these stimulus measures. Indeed, there was discussion about how the next round of QE would be targeted at the MBS market instead of just the Treasury market.

Mortgage rates are benchmarked off Treasury yields. As Treasury yields rise, which they are doing now, mortgage rates should respond. In effect, this backup in Treasury yields has to potential to kill the fragile housing recovery (if there is one) and Bernanke is at risk of losing control of the bond market as an instrument of Fed policy.

If the markets are tightening when the Fed doesn't want to tighten, how will it respond?

In the past, the Federal Reserve has used interviews and leaks after significant announcements to "clarify" its statements. Watch for further statements in the days to come to see the Fed's reaction to the backup in bond yields. On the other hand, if there is no comment within the next couple of weeks, then I would interpret the silence as a signal that the central bank is comfortable with a rise in bond yields.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.  
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


JGW said...

In regards to commodities:

David Merkel said...

This is just a picky point, but mortgages are priced off of swaps, which are highly correlated with Treasuries, but during times of stress or euphoria, behave differently.

You've been writing some good stuff lately,

Cam Hui, CFA said...

David - I stand corrected.

Anonymous said...

Isn't the failure of the low rates affecting housing have to do more with the failure of the Obama administration's HAMP program at qualifying underwater homeowners rather than with the Fed?

Cam Hui, CFA said...

AT -

Regardless of why housing isn't recovering, or recovering faster, ask yourself these questions:

1) Has the Fed shown any concern about housing?
2) Will rising mortgage rates hurt or help a housing recovery?