I have been bearish on bonds for the last few months and, at times, short various parts of the fixed income universe. Since Ben Bernanke's congressional testimony on July 17/18, which was perceived as dovish, there seems to be a lot of complacency about Treasury bonds. The yield on the 10-year Treasury declined slightly from recent highs, but it is still lingering at a dangerous level. If the 10-year yield breaks to the upside, it could spark a very fast move to 3.50% - 4.00% and cause a lot of pain in the bond market (as bond yields rise, bond prices fall). In this article, I will analyze Treasury yields as well as Federal Reserve policy to assess the potential for a disaster scenario for bonds.
10-Year Treasury Bond Yield
The 10-year has been trading in a range of 2.45% - 2.75% for the last month (yellow box).
If the 10-year breaks to the upside, it could quickly move up to 3.50% - 4.00%. That level would bring the 10-year to the descending trendline that has served a resistance going back to the 1980s. A 4% yield was also the highs from 2009-2010.
(Note: 25.61 represents a yield of 2.561%, just move the decimal point one place to the left)
Bond yields moves in the opposite direction as bond prices and the TLT ETF (TLT) is a commonly used proxy for the price of longer dated Treasury bonds:
The Fed has been using two policy tools to keep interest rates low: forward guidance and bond buying.
The Fed's forward guidance revolves around the statement that it will keep the fed funds rate (its main interest rate) low and it "anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent" (source: FOMC minutes, June 19, 2013 meeting).
Since December 2012, the Fed has been buying $40 billion of mortgage bonds and $45 billion of "longer-term" Treasury bonds per month. This is commonly referred to as quantitative easing.
There has been a lot of talk lately about the Fed tapering down the bond buying. In May/June investors perceived the Fed to be leaning to the hawkish side (ending QE sooner rather than later):
- May 11 - WSJ article: Fed Maps Exit From Stimulus
- May 22 - Bernanke comments in Congressional testimony interpreted as hawkish: Bernanke Doesn't Rule Out Fed Taper In The Next Few Months
- June 19 - Bernanke press conference following FOMC when he discussed potential QE tapering scenarios: Bernanke Says Fed on Course to End Asset Buying in 2014
- July 10 - The minutes from the June 19 FOMC meeting came out and disclosed the growing consensus for tapering: Half of Fed sees 'QE' ending late this year
Bernanke and other Fed officials were later perceived to backtrack from the hawkish stance:
- July 10 - Bernanke comments at event perceived as dovish: Bernanke Supports Continuing Stimulus Amid Debate Over QE
- July 17 - Bernanke's congressional testimony interpreted as dovish: Bernanke Accentuates the Dovish Side of Fed Policy
In May/June there was the perception of a hawkish Fed and in July the pendulum swung toward the perception of a dovish Fed. I emphasize the word perception, because the basic communication from Bernanke and the Fed has been the same: QE will end at some point, but the decision will be data dependent. The swing in perception says more about what the market wants to hear than what the Fed is actually saying.
Over the last few months I have listened to many hours of Bernanke's speeches and Congressional testimony. But, the most important datapoint for Fed-watchers was the statement in the minutes from the June 19 meeting: "About half of these participants indicated that it likely would be appropriate to end asset purchases late this year" (see link above). The chorus of tapering supporters is getting stronger.
The fact that the market now perceives the Fed to be leaning to the dovish side (tapering later rather than sooner), may be leading to a big letdown from the next Fed meeting. I don't expect the tapering to start at the upcoming July Fed meeting, but we may get a signal that would swing the perception pendulum back toward the hawkish side.
The New Fed Chair
The race to replace Bernanke is heating up, see Obama Says He Has Narrowed Decision on Next Fed Chairman.
(Also, Fed Governor Elizabeth Duke announced that she will step down on August 31.)
There is going to be a lot of turnover at the Fed in the next few months, which makes interpreting Fed more difficult. Even if Fed watchers have a good understanding of what Bernanke wants today, he may be a lame duck in a few months. And, it will take a while until we know who will replace him and the makeup of the Federal Open Market Committee [FOMC] going forward.
The lack of clarity about the Fed's current intentions and the lack of clarity about who will make up the next FOMC are good reasons for bond investors to be cautious.
Bernanke has emphasized that the decision about tapering, and eventually ending QE, will be data dependent. The Fed looks at a lot of data and the unemployment data is high on the list. There are many ways to measure the health of the jobs market, but the unemployment rate and the non-farms payroll report are the most common measures:
The June numbers (released on July 5) seemed strong. It doesn't seem likely that the half of the FOMC in the tapering camp would change their mind based on this data.
To recap so far, the market currently perceives the Fed as leaning toward the dovish side. But, half of the FOMC is in the more hawkish camp of tapering soon. The Fed is data-dependent and the recent data doesn't seem like it will sway the pro-tapering crowd toward the dovish side. This dynamic seems like it is setting the table for a big disappointment if/when the Fed says/does something that will be perceived as hawkish.
Bond Market Investors
There are many investors in the bond market and they all have different investment objectives and time horizons. I want to look at four types of investors and how they are positioned for the current rate environment and a potential rise in interest rates.
The four types are: structural investors, retail investors, the bond kings and the Fed.
Structural investors are insurance companies, pension funds, foreign central banks, foreign investors and others that are constantly buying Treasury bonds because they need to. James Moore of Pimco discussed this recently:
"Amid the rush to the exits by investors fearful of a so-called bond bubble, one group has been buying, sometimes aggressively. Who are these contrarians? What do they see that the broader public doesn't? Answer: They are managers of America's corporate pension funds and insurance companies. They are buying long bonds. And their motivations offer lessons to the stampede of sellers." (Who's Buying Now?, Pimco, July 8, 2013)
The structural investors will probably continue to buy Treasuries regardless of what happens to interest rates.
Some retail investors behave like structural investors, but others are more sensitive to interest rates. Retail investors have been selling bonds. The Wall Street Journal reported on July 25:
"Investors withdrew an estimated $43 billion from taxable bond mutual funds last month, the largest-ever monthly outflow, according to the Investment Company Institute." (Bond Investors Turn to Cash)
If interest rates rise further (and bond prices fall), I would expect more selling from retail investors.
Next, the bond kings. Bill Gross of Pimco and Jeff Gundlach of Doubline are two of the largest bond investors and I have a lot of respect for both of them. Interestingly, both are bullish on Treasury bonds (meaning they expect bond prices to decline).
On June 25, Bill Gross wrote:
"All this suggests that investors who are selling Treasuries in anticipation that the Fed will ease out of the market might be disappointed. If inflation meanders back and forth around the 1% level, Mr. Bernanke may guide the Committee towards achieving not only an unemployment rate but also a higher inflation target." (The Fog That's Yet to Lift)
In the July 2013 Investment Outlook, Bill Gross wrote:
In any case, if frontend curves are up to 50 basis points cheap, then intermediate curves - the 10-year Treasury - may be as much as 35 basis points too cheap. They belong in our opinion at 2.20% instead of 2.55%. (The Tipping Point)
So, Bill Gross and Pimco expect the 10-year to go to 2.20% in the near term.
In early June, Jeff Gundlach predicted that the yield on the 10-year would end the year at 1.7%. And, later in the month he reiterated his bullish perspective on Treasuries, meaning that he expected yields to fall (source: Business Insider).
For a good summary of the performance of well known bond funds over the last few months, please see Top fund managers were blindsided by U.S. bond market carnage.
I am concerned that there is too much complacency in the bond market. The bond kings expect the 10-year yield to decline. They have held this position for a few weeks/months and have been wrong so far. If, for whatever reason, the 10-year yield moves in the opposite direction many bond investors could be caught off-guard again, which could lead to more selling. And, selling begets even more selling. Not to mention that retail investors seem very impatient with their bonds funds and may pull more capital out of these funds if they see further declines.
The fourth type of investor is the Fed. The Fed has been buying $45 billion of Treasury bonds per month (as well as $40 billion of mortgage bonds). At some point in the next few months the Fed will likely slow the pace of its bond purchases. I expect that the Fed will taper its purchases of Treasuries more than mortgage bonds because the Fed will want to continue the direct support for the housing market longer. It is possible that we will see the Fed reduce its purchases of Treasuries by $10-20 billion per month soon. The Treasury market is big, but losing this much demand will probably have some impact.
Considering that the 10-year yield is at a vulnerable level, losing any demand cannot be good and may lead to more declines in bond prices and higher yields.
The debt ceiling has been in the background for a while as the government avoided hitting the debt limit through a combination of good luck and better economic outcomes. But, the debt ceiling debate may come back in the next few months. Bloomberg reported today:
"When members of Congress return from their August recess, they and the president will face several decisions affecting the economy, including determining federal spending levels and raising the government's $16.7 trillion debt limit. Republican lawmakers are demanding spending cuts in exchange for raising the debt ceiling while Obama is arguing that austerity will stifle the economic recovery." (Lew Says Congress Must Avoid Last-Minute Drama on Debt Limit)
It is hard to know when the debt ceiling debate will come back and there will be a lot of political posturing beforehand. However, it is another risk for the bond market.
In March, Bernanke gave a speech about the fundamental drivers for the 10-year Treasury yield and presented this chart about the expected rise in the yield:
(Source: Bernanke's Long-Term Interest Rate speech, see link above)
The 10-year was expected to reach a yield in the mid 3% range in 2015.
The rise in interest rates is expected to be smooth and steady according to these projections. The markets, however, have a way of jumping the gun.
If interest rates are expected to get to a certain level, they will probably get there sooner and faster than the models predict.
The 10-year Treasury yield has been trading in the 2.45% - 2.75% range for the last month. If it breaks to the upside, the yield may very quickly reach 3.50% - 4.00%. An increase in yield represents a drop in price. This would be a big move and a disaster scenario for bonds, with repercussions across the fixed income universe.
The 10-year must first move above 2.75% for this to trigger. As they say, no trigger, no trade. Until that happens, maybe Bill Gross and Jeff Gundlach are right and yields will drop (and bond prices will rise).
However, I am very cautious. There seems to be a lot of complacency in the market. Market participants think that the bond investors will behave rationally and not drive up the yield on the 10-year because the Fed has given forward guidance that short-term rates will remain low and inflation is subdued.
But, we know that rates will rise at some point.
The question is the timing. There may be a number of catalysts over the next few months that could spark a sell-off in bonds (and a jump in rates), including: the beginning of tapering, the appointment of a new Fed chair, the appointment of other new FOMC members and debt ceiling drama.
With many big bond investors thinking that rates will go down, a move in the opposite direction could catch them off-guard and cause more dislocations. Furthermore, retail investors were quick to sell at the first sign of losses and may come back for more selling.
The Treasury market seems vulnerable, which may lead to a disaster scenario for bonds: a quick move on the 10-year to 3.50% - 4.00%. I am on the lookout to see if we get a trigger to set off this move.
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