Whenever former Fed chief Alan Greenspan was praised for delivering a clear message on US- monetary policy, he used to reply, “I guess I should warn you. If I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.” On June 7th, Greenspan set off the alarm bells on Wall Street by telling viewers of CNBC that the time had arrived for the Fed to begin tapering its $85-billion a month bond buying binge, even if the US-economy isn’t ready for it. “The sooner we come to grips with this excessive level of assets on the balance sheet of the Federal Reserve, - that everybody agrees is excessive, - the better,” he said in a “Squawk Box” interview. “There is a general presumption that we can wait indefinitely and make judgments on when we’re going to move. I’m not sure the market will allow us to do that.”
Greenspan said he’s not sure the markets will allow an easy exit. “If the Fed moves too quickly in reining in QE, it could shock the market, which is already dealing with a very large element of uncertainty. Gradual is adequate, but we’ve got to get moving. Bond prices have got to fall. Long-term rates have got to rise. The problem, which is going to confront us, is we haven’t a clue as to how rapidly that’s going to happen. And we must be prepared for a much more rapid rise than is now contemplated in the general economic outlook,” he warned.
Two weeks later, on June 19th, Fed chief Ben Bernanke triggered one of biggest financial panics since 2008 by hinting that the Fed could begin scaling down its $85-billion per month QE-scheme, much sooner than expected. He spent the next six weeks trying to stabilize the bond market by explaining in painstaking detail the precise timing and conditions under which “tapering” might or might not take place.However, in regards to the panic sell-off in US-bonds and stocks in the month of June,a Wall Street Journal editorial said, “The selloff may be more than anything a side-effect of investor addiction to the world’s central bankers.”
“One explicit goal of the Fed’s monetary interventions has been to push up asset prices, and it has succeeded. But to the extent those price increases are a function of speculative money flows, - they were bound to correct eventually.” And the Fed is doing the right thing. Central banks can't keep floating the world economy forever, and in our view - the sooner the withdrawal begins the better,” the WSJ editorial said.
The main reason for tapering QE-3 has very little to do with the notion that the US-economy is on sound footing. Instead, just the opposite is probably true. The fragile US-economy might find itself sinking into a full blown recession by the first quarter of 2014. However, the Fed’s determination to start scaling down QE-3 is essentially in reaction to the demands of the Bank of International Settlements (BIS), - the central bank of the world - which says it is time to rethink US-monetary policy. The BIS argues that blowing even bigger bubbles in the US-stock market can do more harm to the US-economy than the old enemy of high inflation. Thus, going forward, the costs of continuing with QE now exceed the benefits.
A BIS working paper that traces booming stock markets over the past 110-years, finds that they nearly always sink under their own weight, - and causing lasting damage to the local economy. Asset bubbles often arise when consumer prices are low, which is a problem for central banks who solely target inflation and thereby overlook the risks of bubbles, while appearing to be doing a good job. There’s also the “Greenspan and Bernanke Put” – the implicit expectation that the Fed would not block a liquidity driven bubble in the stock market, and would quickly inject liquidity into the markets, to provide a safety net for speculators, and restore investors’ confidence whenever risky bets go sour. “Lowering interest rates or injecting liquidity when negative news materializes, but not hiking them as bubbles build-up, can be rather insidious in the longer run. They promote a form of moral hazard that can sow the seeds of instability and costly fluctuations in the real economy,” the BIS warned.
So just how can the Fed pull off its next magic trick? That is to say, how can the Fed scale down its QE-3 injections on the one hand, while on the other hand - prevent the yield on the 10-year T-Note from climbing above the psychological 3% level? US-Retail investors plowed as much as .2-trillion into bond funds during the 4-½ years ending May ’13. However, they’ve become jittery over the prospect of the Fed scaling down QE-3, and they’ve already liquidated one tenth of their holdings of bond funds in the past three months. China and Japan were net sellers of a combined -trillion of US T-notes in June. And the US Treasury is expected to sell 0-billion of new debt in the upcoming fiscal year.
With all these bearish forces working against the bond market, how can the Fed prevent an upward spiral in interest rates that could deal a knockout blow to the US-economy, and burst the stock market bubble? China's deputy Finance chief Zhu Guangyao and central bank Vice Governor Yi Gang, are warning the Fed, that it must also consider when and how fast it unwinds QE, in order to avoid harming Emerging markets. “On G-20 monetary policy, the focal point must be on how to minimize the external impact when major developed countries exit or gradually exit quantitative easing, especially causing volatile capital flows in Emerging markets, and putting pressures on Emerging-market currencies,” Yi said.
According to a March ’12 working paper written by economists at the Chicago Fed, it says the Fed could assert itself on the Treasury yield curve by simply issuing verbal clues on the future path of short-term interest rates. This strategy, dubbed “Forward Guidance,” is utilized to cap longer-term bond yields. “It seems possible for the FOMC to change longer term interest rates out of its control by promising to persistently lower the shorter term rates within its control,” the authors wrote. So there’s the idea that the worst could be over for T-bonds, if the Fed sticks to its “Zero Interest Rate Policy,” (ZIRP) at the front end. The Fed is pledging to keep the fed funds rate pegged near zero for as long as the jobless rate is above 6.5%, and the inflation rate is below the +2.5% level. Since the US-government has the exclusive right to fudge the economic data for its own political purposes, - it's reasonable to expect the Fed to get the political support its needs from governments apparatchiks, and could keep the fed funds rate locked near zero percent, and in turn, keep the 2-year T-note yield submerged below 50-basis points – for as far as the eye can see.
In Chicago, the federal funds futures contract for Dec 2014 delivery is yielding a paltry 0.36%, meaning traders don’t see any Fed rate hike until 2015. Yet despite the anchor of ultra-low short term rates, it appears as though the Fed’s magic spell over the 10-year T-note market is starting to wear off. Prices of long-dated US-bonds have plunged, and are on track for their worst 4-month stretch since 1996. The Barclays” index for Treasuries that mature in 20-years or longer, (ticker symbol TLT) has fallen -13% so far this year, - its worst performance since it was launched in 1976. T-bond prices have plunged even though the US-economy is growing at a snail’s pace, and is at risk of sliding into a full blown recession next year.
In a speech given on March 3rd, Fed chief Ben Bernanke tried to explain that the yield on the 10-Year Treasury note can be divided into three sub-rates: expectations about future inflation rates, expectations about what the Fed will do with the fed funds rate, and the term premium (the amount that Treasury holders demand to be compensated for going further out on the curve). Of these three variables, the Fed has the most influence over the fed funds rate. The Fed is praying that ZIRP can cap the upward spiral of longer-term bond yields.
Such as long-shot possibility could materialize, however, if the 53-month old Bullish rally in the US-stock market starts to fizzle out, and if the stock market begins to slide into a nasty correction of -10% or more. If the stock market begins to nosedive, due to the realization that the US-economy is sliding into a full blown recession, including job losses, then there could be a rotation from the high flying equities and into safer haven T-bonds.
In spite of the dismal performance, technical analysts have noted that there were prior flare-ups, with 10-year T-bond yields increasing +100-bps, +195-bps, and +144-bps respectively. Each of these prior upturns in yields eventually fizzled out and reversed. The Fed’s lock down on the short end of the yield curve and massive purchases of T-bonds helped to place a ceiling over the long-end. But now that the Fed is expected to scale down QE-3, in an effort to prevent the emergence of an even bigger bubble in the US-stock market. Traders find themselves sailing into new and unchartered territory, and trying to figure out how to profit from the Fed’s exit from its radical QE experiment.
For investors trying to pinpoint when the Fed will unwind QE-3, the message from researchers at a pair of influential regional Fed banks is clear: “don’t bother.” More crucial will be signals from the Fed on when it will start to raise short-term interest rates from their current near-zero level. “Our analysis suggests that communication about when the Fed will begin to raise the federal funds rate from its near-zero level will be more important than signals about the precise timing of the end of QE3,” San Francisco Fed senior economist Vasco Curdia and New York Fed senior economist Andrea Ferrero wrote. So far however, just the opposite appears to be true, as the Fed is losing control of the bond market, and the long dormant T-bond vigilantes are gaining the upper hand, as it weans itself off QE.
Bank of England (BoE) Adopts “Forward Guidance” Scheme
Mervyn King, who sat in BoE governor’s chair for 10-years, became addicted to the hallucinogenic QE drug in the latter half of his reign. For six straight months, King joined with his fellow BoE board mates, Paul Fisher and David Miles pleading for a resumption of QE, after its was mothballed in Nov ’12. King argued in favor of a modest resumption of QE injections, at £25-billion, but was outvoted each time by a sizeable margin of 6-to-3, including on his final policy meeting on June 19th. The six other members of the BoE’s monetary committee had kicked the QE habit, and voted to freeze QE at £375-billion.
The BoE rebels refused to sink deeper into the QE-quagmire, warning that it could further inflame the scourge of inflation, and could further inflate speculative bubbles in the equity markets. “Monetary policy is already exceptionally accommodative, and further Gilt purchases could contribute to an unwarranted narrowing in risk premia and complicate the transition to a more normal monetary stance at some point in the future,” the minutes showed. Furthermore, the more responsible members noted that Britain’s consumer inflation rate has held above the central bank’s target of +2% for most of the past five years.
Sensing the stiff resistance from the BoE rebels, the new incoming BoE chief, Mark Carney decided to follow the playbook of the Federal Reserve, and signaled on July 4th, that the BoE would try its hand at “forward guidance.” The BoE pledged to keep the bank’s base lending rate locked at a record low of 0.50% for longer than London futures traders had expected. “The implied rise in the expected future path of bank rate is not warranted by the recent developments in the domestic economy,” the BoE said in a statement.
The BoE was referring to the longer-dated Sterling Libor futures contracts that are building up expectations of a BoE rate hike to 1% before December 2014. Yet despite the BoE’s gambit with “forward guidance,” it has gained very little traction. Today, the Sterling Libor futures contract for Dec ’14 delivery is yielding 0.90%, signaling a 100% chance of a quarter-point rate to 0.75% within the next sixteen months, and a better than even chance of a half-point rate hike to 1% by the end of 2014. The downturn in British Gilts continues despite the BoE’s trickery. Since May 1st, 10-year Gilt futures prices have tumbled -10%, lifting their yield to as high as 2.75%, before futures prices stabilized on short covering.
Most worrisome, the yield on the British 10-year Gilt is surging higher, even though the UK-economy is still skating on thin ice. The UK-economy is buffeted by the troubles on the Continent, - Britain’s largest export market, and fiscal austerity at home. George Osborne, the Chancellor of the Exchequer, has doubled down on his effort to rein-in the UK-budget deficit, in reaction to Moody's decision to strip the UK of its coveted Aaa credit rating in Feb ‘13, and cutting it to Aa1. On June 26th, Osborne announced £11.5-billion of new spending cuts in the 2015/16 fiscal year, including more public sector job cuts.
Inflation is running at a +2.9% clip in the UK, while workers’ wages saw one of the largest falls in the European Union during the economic downturn. The figures, collated by the House of Commons library, show average hourly wages in the UK have fallen -5.5% since mid-2010, adjusted for inflation. That is the fourth-worst decline among the 27 EU nations, and the biggest drop since 1987. By contrast, German hourly wages rose +2.7% over the same period. Other countries also fared better than the UK. Spain had a -3.3% drop and salaries in Cyprus fell by -3%.French workers saw a +0.4% increase.
Desperate to cap the upward surge in Gilt yields, at the downward sloping trend-line residing at 2.75%, the BoE broke with tradition and adopted a de-facto dual mandate. On August 7th, the BoE unveiled a near carbon copy of the Fed’s forward guidance scheme. It pledged to keep its base lending rate locked at a record low of 0.50%, until the jobless rate falls to 7% or below, which it said could take three years. However, the gimmickry didn’t dupe British Gilt traders, who don’t believe the BoE can keep its foot on the stimulus pedal for another three years without elevating the UK’s already high inflation to an even higher plateau. That challenge was made all the more difficult, when BoE member Martin Weale voted against the forward guidance scheme, saying it risks fueling a higher rate of inflation.
On June 12th, the Bank of England’s Andrew Haldane told the Treasury Select Committee that the biggest risk to financial stability would be a spike in G-7 bond yields should the bond bubble burst. “If I were to single out what for me would be the biggest risk to global financial stability right now, it would be a disorderly reversion in government bond yields globally. We’ve seen shades of that over the last two to three weeks. We have intentionally blown the biggest government bond bubble in history. We’ve been vigilant to the consequences of that bubble deflating more quickly than we might otherwise have wanted. That’s a risk we need to be very vigilant to,” he warned.
Debunking the “Forward Guidance” Gimmick
The idea of trying to lure fixed income investors into purchasing long term T-bonds, by vowing to keep short-term rates low for an extended period of time, is a desperate gambit that’s fraught with great danger. On June 2nd, the chief economist of the BIS, - Stephen Cecchetti explained in a conference call, “While there would always be uncertainty over the correct level of interest rates, it is not normal that official interest rates should be near zero, and that markets should be effectively penalizing investors for holding longer-term debt. Yields will go up, as the economic recovery takes hold, but the ride to normality will almost surely be bumpy, with yields going through both calm and volatile periods, as markets price in sometimes conflicting news,” he warned.
Prices and yields move inversely to one another, so a generalized rise in bond yields can result in sharp losses, at least on paper. Mr. Cecchetti warned that the scale of such losses could be greater than ever before, owing the explosion of government debt in most developed markets.
And counter-intuitively, bond holders can suffer losses, even when the local central bank is busy cutting short-term interest rates to record low levels. Such was the case in the Australian T-bond market, - where 10-year T-bond yields have been trending higher for the past 13-months, even while the Reserve Bank of Australia (RBA) was engaged in a rate cutting campaign. On August 6th, the RBA lowered its overnight cash rate to an all-time low of 2.50%, and on August 19th, it left the door open for a further cut in the cash rate to 2.25%, in a bid to nudge the exchange rate of the Australian dollar to lower levels.
Yet while the RBA was lowering its cash rate -100-bps to 2.50%, the yield on Australia’s 10-year T-bond moved in the opposite direction, climbing +125-bps higher to above 4% in August ’13. As is the case in London and New York, - Australia’s 10-year T-bond yields was climbing, despite signs that China’s economy is slowing, which in turn, is weakening prices for commodities such as iron ore and coal, - Australia’s top-2 exports. Australia’s Treasury can boast of being one of only eight countries with a triple-A credit rating from all three major ratings agencies, yet over the past few months, Australia’s T-bonds have fared almost as badly as lower rated British Gilts and US T-bonds, as foreign investors headed for the exits.
The best time to buy long-term T-bonds is closer to the tail-end of a tightening campaign, in which the central bank has hiked its overnight loan rate to a level that’s high enough, to induce a sharp slowdown in the local economy. Sometimes, central banks will overshoot and trigger the beginning of a recessionary cycle. The central bank can lay the groundwork for a sharp drop in long-term bond yields, if it keeps its overnight loan rate elevated at higher levels for a long period of time. For example, the RBA engineered a sharp decline of -300-bps in the Aussie 10-year T-bond yield to a record low of 2.80%, (see chart above), having paved the groundwork with seven rate hikes, totaling +175-bps to as high as 4.75% in late-2010.
Even before the RBA began its subsequent easing cycle, with its initial quarter-point rate cut to 4.50% in Nov ’11, the yield on Australia’s 10-year T-bond had already dropped -160-bps lower to 4% over the prior 11-months. The central bank was simply following the signals of the T-bond market that was telegraphing lower RBA interest rates. As noted earlier, the last four RBA rate cuts to 2.50% were not well received by the longer-end of the Aussie yield curve, having resulted in higher T-bond yields. Soon, the RBA would realize that further rate cuts are counter-productive, and could lift inflation, - unless the reason for a final rate cut to 2.25% is for the sole purpose of knocking the Aussie dollar lower.
The bond vigilantes hold upper hand over central banks, as the 30-year old secular Bull market for Bonds reached its dead-end in 2012. Although T-bond yields in the developed world have bumped upwards by +1% or more, in recent months, they remain near historic lows. Trying to push T-bond yields lower for a prolonged period of time, is like trying to keep a helium balloon submerged under water. Thus, T-Bond yields in Australia, Britain, and the US are expected to move erratically higher in the months ahead.
The RBA is near the trough of its rate cutting cycle and could keep its overnight cash rate depressed at historic lows of 2.50% for the rest of 2013. Until the RBA starts to reverse itself and begins a new rate hiking cycle, the Aussie dollar is still at risk of a further devaluation, and the 10-year Aussie T-bond market is at risk of further losses, resulting in higher yields.
The forward guidance gimmick put forth by the BoE and the Fed shouldn’t fool fixed income investors into buying long-dated T-bonds. Instead, the scheme might backfire, by fueling bubbles in the local stock markets, and further inflame the bearish sentiment that’s raging in UK-Gilts and US T-Notes. The British Gilt market typically tracks the direction of US T-Notes. So if the Fed begins to whittle down QE-3 to about -billion per month by December, as expected, - it could deal further pain to bondholders and lift British and US-bond yields higher in the months ahead. On the other hand, if the long awaited tapering of QE-3 triggers the long awaited correction in the British and US-stock markets, results in sustained equity losses of -10% or more, - the loss of a few trillion dollars of wealth in the stock markets could be more effective at capping bond yields, than the gimmickry of forward guidance.
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