The yield on the 10-year U.S. Treasury has spiked from 1.6% in the middle of May to the current 2.65%. In Bond Land this is a big move. Under normal circumstances a rise in interest rates would be caused by some fundamental factor such as an unexpected rise in the inflation rate or some data portending a much improved outlook for the economy. But these are not normal times and the impetus for the recent rate rise was the Federal Reserve may begin to taper its bond purchases sooner than expected.
To put this fear into perspective, let’s review the Fed’s current monetary policy stance. In a word, it’s highly accommodative. That is to say, the Fed is pumping as much money (or liquidity, if you must) into the economy with the hopes of actually stimulating economic and job growth. The current blunt instrument of choice is quantitative easing (QE, for short), whereby the Fed increases the money supply by buying bonds in the open market. The current rate of purchases is $85 billion per month. It’s important to note that use of QE is highly unusual, and is, in its own right, a signal that these are not normal times.
The Fed has announced that it would end its QE activity when the U.S. unemployment rate reaches 6.5% and inflation rises about 2%. The latest data suggest that we are still far away from these trigger points. The consensus expectation was that slowing down the bond purchases (tapering in the parlance) would not happen before year end. The language from the most recent FOMC meeting was interpreted by some Fed watchers to suggest that the tapering would happen earlier than this. And this led to the sell-off in the bond market.
When I started working on Wall Street, my firm had a very creative and clever market strategist who put together and published a chart book showing many important economic and capital market price series presented in a unique and highly useful fashion. On top of every page of this chart book was a graph showing his assessment of Fed monetary policy, with three main settings – easy, neutral and tight. By looking at these charts, one could see easily how changes in monetary policy affected the economy and the markets. Easy monetary policy tended to stimulate the economy and was a positive for bond and stock markets. A neutral policy stance meant that monetary policy was not impacting the economy or the markets one way or other. Fed tightening represented the proverbial “taking away the punch bowl;” was negative for bonds and often proceeded a recession.
Back in the day, easy monetary policy was most easily executed by lowering the Fed Funds rate. Measuring the Fed’s stance was fairly easy; all one had to do was gauge the level and direction of the Fed Funds rate.
When the Fed Funds rate was lowered to zero, many thought that the Fed had exhausted its easing options. When the economy (and jobs) failed to recover as expected in response to a zero percent Fed Funds rate, the Fed pulled QE out of deep storage to see if it would work better than just a zero percent Fed Funds rate. The efficacy of the QE programs is the subject of much debate, and is well beyond the scope of this note. Suffice it to say, that QE might be characterized as “super-duper” easing by the Fed.
So when the Fed backs off (tapers, if you will) from “super-duper” easy monetary policy, what do you get? Tight monetary policy? No, you get super easy monetary policy. After more tapering, you might get back to good old simple plain vanilla easy monetary policy. The notion that the Fed is tightening because it might be tapering bond purchases before the end of the year seems like a weak excuse to aggressively sell bonds. But, hey, I’m an equity guy, so what do I know…
Well, I do know some really smart bond guys, and here’s what one of them thinks about this whole tapering stuff.
The first step will be to buy fewer bonds. The next step will be to let existing bonds purchased by the Fed mature and not be reinvested. This will pull a bit of liquidity out of the system. The next step will be to actually sell some of the bonds the Fed owns. Then the Fed could stop paying banks for the reserves they are holding. All of these steps will take some time. Only when all of these steps are completed would the Fed begin to actually adjust the Fed Funds rate higher. Even then, Fed policy would be “easy” on its way to “neutral,” and perhaps still far away from “tight.”
The conclusion from this smart fellow was that it is way too early to try to guess the timing of any of this, and potentially foolhardy to adjust one’s portfolio based on what the Fed might do over the next few months.
Keep in mind that if the Fed does begin to actually back off of its “super-duper” easy stance, it will be because the economy is growing in a healthy and self-sustaining way. That actually sounds like good news to me.