Wednesday, June 12, 2013

12/6/2013: Bond Markets: Is Canary Kicking the Bucket?

I have written before about the prospect of the Fed starting unwinding of the QE operations. Here's my summary forward view.

Stage 1: the Fed will reduce the rate of QE print ('taper on'). This is inevitable and it is already driving 10-year Treasury yields up - in last 40 days, by some 50bps. The same is also inevitable for the Euro area, albeit via a different mechanism (unwinding of excess liquidity supply to the banks, plus scaling down of any expectations for OMT to kick in), driving the Bund up some 35bps.

In both cases, macro news-flows and inflationary pressures pointed to the opposite direction for yields. This is confirmed by the differences in risk pricing indices in the bond markets (MOVE index: Merrill Lynch Option Volatility Estimate (MOVE) Index on US Treasuries) as opposed to the equity market volatility index (VIX). MOVE has gone almost double from around 47-48 in early May to over 80 recently. Levels around 80 are consistent with the height of the peripheral euro area crisis back in 2012. Over the same period of time, VIX is up from around 13.0 to 16.0 and during the height of the euro area crisis it was averaging closer to 40.

Stage 2: In the follow up stage, the Fed will have to engage in more than simply scaling back new purchases. Here, the unwinding will begin in earnest and the Fed will have to sell longer-dated bonds into the market.

For now, we are just embarking on Stage 1. Emerging markets and corporate bonds, as well as euro periphery bonds are all signalling the same story: yields are pressured up. During May, US investment corporate bonds fell 2.7%, while junk bonds were down 2.3%.

Now, in the longer term,  when US gross interest rate rises relative to the euro area, forward exchange rate must rise relative to the spot and dollar will weaken forward. This covered parity relationship tends to hold over the longer periods of time under normal market conditions. In May-June so far, Dollar is 5% weaker than EUR, and over 2% weaker than CHF (linked to EUR). However, Dollar is stronger 22% than JPY and virtually unchanged on GBP, dollar strengthened with respect to the emerging currencies.

However, in the short run we are not in a normal economy. As US economy continues to improve, few things will happen:
1) The Fed will continue tapering on the QE in the short-term
2) Expected unwinding of QE (rising rates, instead of lower speed of purchasing of Treasuries as in (1)) will enter expectations in the market but in a longer term, rather than any time soon
3) Bond yields will continue rising and volatility will remain amplified. Long-term US equilibrium is for 10 years at 3.0-3.2% and short-term overshooting that range, for Bund - at current rates, around 2.5-2.8%.
4) Fed will be watching the speed of increases and manage unwinding process accordingly to keep yields from overshooting 3%-or-so target by a significant margin.

All of this means that news-flow will be crucial in months to come as it will be signalling both short-term and long-term changes to the Fed position (usual stuff about the rates), but also strategy (severity of (1) above, or switch to (2) from (1)).

In the short term, dollar will see pressures to appreciate as interest rates will remain intact at policy level and it will take time for higher Treasury yields to transmit into higher real interest rates in the US, inducing slowdown in the economy. Until that happens, economic recovery will be pushing up equities and USD.

In the longer run, however, this pattern will be altered: improved economic news will signal forward switch from (1) taper off to (2) unwinding. Yields will put pressure on real interest rates (3) and policy rates will move up. This will lead to subsequent devaluation of the USD toward equilibrium and a slamming of the breaks on the recovery.

The emerging markets and corporate bonds squeeze are not simple reallocations of liquidity. Truth be told, there is nowhere for liquidity to 'reallocate', given yields. Instead, these are early warning systems at work. Now, to see the underlying iceberg we are heading for, recall this

Updated: series of very interesting interviews on the issue of monetary exit:

and an interesting post on term premia due to QE:

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