Kamis, 20 Juni 2013

The bond market is unwinding its doom and gloom fears

The most important message to be found in today's bond market action (i.e., sharply rising real and nominal yields on Treasuries) is that the Fed's purchases of Treasuries did not artificially distort the Treasury market. Yields were low because the market expected the economy to be very weak for a long time—not because the Fed's purchases made them low. I commented at length on this about a month ago; here's an excerpt:

It's my impression that most market participants have been persuaded by the flow argument: namely, that the Fed's massive QE3 purchases have artificially depressed market interest rates. After all, that's been the Fed's stated intention: to buy lots of bonds in order to depress interest rates and thereby stimulate borrowing and economic activity. This line of reasoning says that the fact that 10-yr Treasury yields averaged an exceptionally low 1.75% over the past year has nothing to do with the market's view of inflation or economic growth; Treasury yields have in fact become meaningless inputs to valuation models and offer no insight into market and economic fundamentals, other than as a distorting influence. 
I've argued to the contrary on many occasions over the years. I believe that interest rates are determined by the market's willingness to hold the existing stock of bonds, especially since Fed purchases on the margin represent only a small fraction of the existing stock. I think the Fed can only influence yields to the extent that the market's view of the economy is similar to the Fed's. If both expect the economy to be very weak, yields will be low, and prices will behave as if Fed purchases of bonds to stimulate the economy are in fact achieving their stated objective. But if the market thinks the economy is improving and/or inflation is rising, then no amount of Fed purchases will be able to keep yields from rising. That's the situation today, and it's been unfolding (in fits and starts) almost from the day QE3 began.

And so it is that despite the Fed's purchases of $45 billion of Treasury notes and bonds every month, and $40 billion of MBS every month, 10-yr Treasury yields have jumped some 80 bps and MBS yields have jumped almost 100 bps:



What has changed since the beginning of last month that has caused Treasury yields to soar? Only one thing: the market has come to believe that indeed—as the FOMC's recent statement suggested—the outlook for the economy has improved a bit. The Fed has been telling us for a very long time that it would eventually stop buying bonds, but until recently the market just didn't believe it would ever come to that; the market thought the economy would be mired in a slump for as far as the eye could see. The "new normal" economy was going to last forever. Now, however, the market is beginning to see some light at the end of the "new normal" tunnel: things might be getting better. And of course, if the economy does improve, then the Fed will not only taper and then stop its QE purchases, but it will sooner or later begin to push short-term interest rates up. Even if the Fed waits until next year to raise short-term interest rates, which seems likely, the market can now believe that short-term interest rates will rise, and so today the market is adjusting to what it believes will happen in the next several years.

If the market thinks the economy is improving and/or inflation is rising, then no amount of Fed purchases will be able to keep yields from rising. That is what today's market action is all about.


So it makes sense for Treasury and TIPS prices to be plunging/yields to be rising, because the market now believes that interest rates will be higher in the future than it thought until recently. And it makes sense for inflation expectations (as measured by the spread between TIPS and Treasury yields) to be declining, because the Fed is now less likely to make a big inflationary mistake.


It also makes sense for gold prices to be plunging, since the market now realizes that the Fed is not going to be doing QE forever, which in turn implies that the risk of runaway inflation and dollar debasement is much less than previously feared. As I mentioned last April, gold had reached incredibly high levels on the back of speculative fever and concerns over too much Fed easing. Gold is now well on its way to re-linking with other commodity prices, with a likely price target of $900-1000/oz. Commodity prices in general appear to be under a little selling pressure, but gold is the bigger story since its rise, in retrospect, was extraordinarily overdone. 


It makes sense for credit spreads to be relatively low and largely unaffected by the turmoil in the Treasury market, because the outlook for the economy has improved somewhat. What's bad for Treasuries is not necessarily bad for the economy. Indeed, the prospects for economic growth can be a powerful influence on Treasury yields. Weaker-than-expected growth usually results in lower yields, which stronger-than-expected growth usually results in higher yields. (Higher Treasury yields can be bad for the economy, but only if the Fed is actively tightening in order to slow the economy, as happened in the late 1990s.)


Equity prices have suffered a bit, but that's not so unusual given the enormous changes underway in the bond market. As the chart of the S&P 500 (above) shows, the recent decline in equity prices is still in the nature of a minor correction. It wouldn't make sense for the equity market to collapse just because the outlook for the economy has improved, would it? Higher Treasury yields are not going to bring down the economy; higher yields are the natural result of improved expectations for growth. Growth does not sow the seeds of its own destruction. The Fed is many years away from tightening by enough to threaten growth.



The Vix index has jumped, and that too is not unusual because the market is undergoing a big reassessment of its assumptions and its outlook. But as the charts above show, this rise in fear, uncertainty, and doubt is still relatively minor when viewed from a long-term historical perspective. And that makes sense, because today the market is not worrying about a major deterioration in the outlook, but rather a modest improvement in the outlook. This is not the stuff of doom and gloom; it is the unwinding of doom-and-gloom fears. That's a big difference. 

If this analysis is correct, then the decline in equity prices has only increased the attractiveness of equities. All things considered, it's good news that the outlook for the economy has improved somewhat, and that the Fed is planning to accelerate—however modestly—its plans for unwinding its Quantitative Easing efforts. 

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