"We've had a 30-year bond market rally. These things do not go on forever."
- Richard Fisher, president of the Dallas Federal Reserve, in the Financial Times, June 24, 2013
Fisher caused a stir at the beginning of this week when he indicated his satisfaction with the Federal Reserve's stance on the inevitability of ending its program of bond purchases. His interview in the Financial Times ("Fed fights back against 'feral hogs'") made it clear that the Fed in general is well aware of the high odds of market convulsions in response to any reminders that bond purchases will end once the economy meets the Fed's preset exit criteria (criteria that have been in place since at least 2011). The chart below shows that the S&P 500 continued to rally even as rates rose until the 10-year made new highs for the year in the last 14 months or so.
Source: St. Louis Federal Reserve
Like many, I took particular note that Fisher singled out coordinated action by market participants (what he called "feral hogs") as one of the bigger risks to ending bond purchases and pointedly warned that "my personal feeling is that you don't walk up to a lion and flinch" (in a partner article "Fisher urges Federal Reserve to stand firm over exit policy"). This represents a rarely expressed battlefield mentality. Typically, we hear from the Fed that it has the tools and capability to incentivize and steer the market in its desired direction. The degree and timing of cooperation may be uncertain, but rarely does the Fed paint itself as fighting against actors aligned to undermine its policy preferences. As we watch the market bounce around in its generally downward cascading motion, this battlefield metaphor provides good context; that is, at some point, the Fed will attempt to reassert control over the bond market whether by force (more QE?) or by more jawboning (loosening criteria for ending bond purchases?).
What most caught my attention was Fisher's reference to the historic rally in the bond market (quote above). In reminding the market of the obvious - that this rally must come to an end at some point - this quote also, perhaps indirectly, serves as a reference to consumer behavior that has relied on ever lower rates to consume more and save less. The chart below shows the tight correlation between the rate on the 10-year Treasury and the personal savings rate measured as a percentage of disposable income. The two have enjoyed a generation-plus of persistent decline.
Source: Federal Reserve of St. Louis
Recessions have driven the greatest short-term divergences between personal savings and bond yields as consumers naturally retrench and the Fed lowers rates to encourage a resumption of consumption. So, it is particularly notable to see that the savings rate has now dropped back to levels that preceded the last two recessions.
This chart shows a close-up...
Source: Federal Reserve of St. Louis
The last two times the savings rate dropped to these low levels, the S&P 500 (SPY) was reaching or was at its peak for the cycle. Arguably, the economy was performing more strongly at those times than now (putting aside the underlying weaknesses that eventually undermined economic conditions). If consumers are truly on a path to tapping themselves out, the Fed's projected recovery path that is a pre-condition for ending bond purchases is a tenuous one. The stretched savings rate is reason enough for even Fisher to try to remind the market that the Fed's monetary policy will remain accommodative for quite some time. The looming question may become just how low must the savings rate go before the economic recovery solidifies… and when it finally does, will the exceptionally low savings rate in turn help to undermine that recovery in short order? Moreover, can the savings rate even get any lower if interest rates go higher? Will a higher savings rate slow consumer spending enough to eliminate expectations for bond tapering?
For now, the immediate dramas lie in the gyrations of interest rates and guessing where the market will mark down asset prices to accommodate new rate expectations.
Be careful out there!
Additional disclosure: Short TLT via put spread; also long TBT and long SSO calls.