Treasury investors on a knife-edge as Fed in two minds
For some, citing weak growth and fiscal cuts, there is seemingly no end in sight to quantitative easing in the United States, while others argue rates can no longer decouple from improving economic fundamentals. The Fed has sent mixed messages about its monetary policy course, heaping on allocation risks.
A consensus has been building for months that the Federal Reserve was poised to taper off its monetary easing policy implemented in the wake of the 2008 financial crisis. But that narrative is complicated with mixed economic data. While the economy grew at 2.5% in the first quarter, this was slower than expected and cuts in federal government spending, dubbed ‘sequestration’, and tax increases, will soon impact growth. Figures for April show the unemployment rate remained stuck at 7.6% – though the addition of 279,000 new jobs that month is cause for some hope – while manufacturing output fell. Prices are barely moving either. Inflation in the year to March rose just 1%, well below the Fed’s 2% target.
Some believe the Federal Open Market Committee (FOMC) may increase its $85 billion a month in asset purchases, mostly treasuries, in an effort to nurture the nascent economic recovery.
The committee has pledged to keep its target interest rate close to zero until unemployment falls to 6.5%. The Fed Funds Rate currently stands at 0.25%.
The yield on the 10-year Treasury note was around 1.6% in recent trade, its lowest level this year.
Guy Foster, head of portfolio strategy at Brewin Dolphin, believes the Fed will maintain its bond purchases ‘substantially’ into 2014 to counter fiscal contraction in the economy, weak demand and uncertain labour market recovery.
“Monetary easing is not coming to an end; in fact the FOMC has opened the door to increasing the rate of purchases at future meetings. This is going to provide support for bond markets for at least the rest of the year.
“The lingering perspective that purchases were going to be tapered is something that has been squeezed out of forecasters’ expectations over the last month.
“There’s a real sense from investors that the Fed stands there ready to provide a lot of liquidity and stimulus to an economy which is really starting to slow down and where the last traces of inflation are rapidly ebbing away”, Foster explains.
“Bad news is good news seems to be the mentality at the moment; the worse the economy looks the more likely it is that the Fed will step up and the Fed has now indicated that they would be willing to do that.”
Foster predicts 10-year treasury yields will hold in the 1.5% to 2% range for the rest of this calendar year, on ongoing structural demand from institutional holders, the Fed and other central banks. Traders are also buyers whenever they believe risk is about to sell off.
Highlighting recent improvement in labour market conditions, household spending, business fixed investment and the housing sector, the Fed concludes growth would be much stronger without the government spending cuts and tax rises. Throwing down the gauntlet to Congress, the Fed stressed for the first time that while it may increase the pace of its purchases, it could also reduce them in order to maintain “appropriate policy accommodation”.
“I interpret the Fed’s position as a bit more hawkish,’’ says Paresh Upadhyaya, director of currency strategy US, at Pioneer Investments in Boston. “Saying they may reduce purchases is a way to prepare the markets for an eventual exit.
“I’m sceptical that the weakness that we’re seeing in the macro numbers will be as weak as it was the last two years in the second quarter. So I think the Fed will begin to taper asset purchases in the fourth quarter with the immediate impact that yields are going to head higher before that,’’ Upadhyaya says.
He argues that there is a disconnect between 10-year yields and the economic fundamentals.
“Treasuries are trading below inflation expectations. At 1.6% risk-reward is just not there to be long Treasuries. This is unsustainable and investors are eventually going to demand higher yields and this risk will increase the longer the Fed’s excessively loose policy continues,’’ Upadhyaya explains.
Non market-sensitive buyers – foreign central banks, and the Federal Reserve – have doubled market holdings of US treasuries in recent years to 64%, as of September 2012, while households, banks and the likes of pension funds have reduced their holdings.
Upadhyaya says the tilting point for a rotation is the Fed moving to a neutral or tightening bias so that market-sensitive investors see that the interest rate trough is behind them and that rates are going to more closely reflect fundamentals.
Policy change must be gradual and communicated well in advance to avoid a drastic sell-off in a very short period that could destabilise risky assets sparking panic in global markets.
“Provided the Fed can engineer a soft-landing so that rates only go up gradually, not dramatically, we’ll avoid disruption in financial markets and there will be opportunities to seek returns elsewhere.’’
For now, all eyes will be watching yields for evidence of coming change.