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"Central banks sold a record amount of US Treasury debt last week while bond funds suffered the biggest ever investor withdrawals…

Holdings of US Treasuries held at the Fed on behalf of official foreign institutions dropped a record $32.4bn to $2.93tn, eclipsing the prior mark of $24bn in August 2007. It was the third week of outflows in the past four.

Private investors are also dumping fixed income. Bond funds tracked by EPFR Global, a data provider, saw total redemptions of $23.3bn in the week to June 26. US funds were the worst hit, with withdrawals totaling $10.6bn, but emerging market debt funds also saw record redemptions of $5.6bn."

So reports the Financial Times.

But, wasn't this "break" expected…sooner or later?

Since December 2008, the policy of the Federal Reserve has been to keep its target interest rate, the Federal Funds rate, somewhere between 25 basis points and zero.

The Federal Reserve has achieved this goal.

So, for four and one half years, returns from investing in very short-term assets have been almost non-existent.

In addition, certainly some of the Federal Reserve's quantitative easing caused longer-term yields to be lower, but longer-terms yields reached extraordinarily low levels during this time as funds seeking to escape the European sovereign debt market found the "safe haven" of the US Treasury bond market. These flows were so substantial that the yield on US Treasury inflation-indexed bonds became negative in the fall of 2011 and stayed in negative territory until about two weeks ago.

In order to compensate for low short-term interest rates, investors usually buy into riskier financial market assets or they lengthen the maturities of their holdings…or both.

That, of course, is exactly what happened. Short-term yields were near zero and longer-term yields on US Treasury securities reached excessively low levels.

Yet, to get some kind of higher returns on their investment portfolios, investors bought longer-term Treasury issues, corporate bonds, and high-yield securities.

Sophisticated investors knew this was very risky investing! They knew that at some time in the future that the yields on these longer-term securities would have to rise, and, they knew that the prices of these bonds would be extremely volatile because of their longer maturities. So, if these investors were to extend the maturities of their portfolios to chase higher yields, they knew that they would have to be very nimble and get out of the securities the second that it appeared that long-term interest rates were going to start to rise. In playing this game, one could not be "late" in getting out.

Officials at the Federal Reserve continued to emphasize that the target yield on Federal Funds was expected to stay extremely low, in the zero to twenty-five basis point range well into 2014 with some even thinking that this range might still be in effect into 2015.

Here we get back into the credibility issue with respect to the Federal Reserve. All during the Bernanke tenure as Fed Chairman, Bernanke has been concerned about the financial markets understanding what the Federal Reserve policy is and what the Federal Reserve is trying to achieve in its open market operations. Bernanke has tried over and over again to become more and more transparent, but something seems to always get in the way of investor understanding.

With the officials at the Federal Reserve being so adamant about keeping the Federal Funds rate so long for such a lengthy period of time one began to wonder what they were worried about.

Could the Fed officials be so insistent about keeping the Fed Funds rate near zero in order to steady a jumpy investment community that might start selling longer-term bonds as soon as they smelled any chance that longer-term interest rates were going to rise? Fed officials had to try and convince these investors to stay in longer-term bonds as a part of their monetary scheme. Talking up the idea that short-term interest rates were going to stay low for such an extended period of time, therefore, became a part of the Fed's Open Mouth policy!

What Federal Reserve officials didn't count on was the movement of "safe haven" money from the United States back to Europe and financial confidence rose on the European continent. As these funds began to flow back into Europe, the yield on TIPS moved from negative territory into positive territory.

After this flow began, Mr. Bernanke began talking about how the Federal Reserve might begin "tapering" its purchases of securities connected with the third round of quantitative easing. This just added to the fuel that was being poured on the bond market.

And, as might be expected, the yields on non-inflation indexed bonds also rose. In early May of this year, the yield on the 10-year US Treasury note was around 1.60 percent. On June 24, this security closed to yield 2.60 percent.

The point is, in my mind, that this market sensitivity should have been anticipated. Bond funds knew they were very, very exposed to falling bond prices once bond yields began to rise. This was the situation they were in because of the added risk they had taken to squeeze out a greater return for their portfolios.

In addition to this, as I argued above, the Federal Reserve was aware of this sensitivity because they were intentionally and vigorously arguing that the Federal Funds rate was going to remain a little above zero for another year or so. This "public relations" effort was to keep bond investors from becoming too jumpy.

What happened?

Maybe the Bernanke departure got in the way. If so, this possibility apparently caused Federal Reserve officials to "take their eye off the ball." These officials lost the thread to their main story. As a consequence, these officials had to scramble back into the fray and try and contain the damage that had been done. (See "The Federal Reserve Loses Its Cool.")

Given the need to extend maturities to get yield and the risk exposure this effort consequently brought to the bond funds, it is not surprising at all that the investors responded the way they did in the past several weeks. How the Federal Reserve handles this sensitivity in upcoming weeks is going to be the interesting story.

Source: What's Not To Understand About The Bond Market Exit?