"To me, consensus seems to be the process of abandoning all beliefs, principles, values and policies. So it is something in which no one believes, and to which no one objects."
- Margaret Thatcher
It seems the market can only focus on a few thing at a time. Remember how Europe was a problem? Remember Greece? Have any of the problems over there really been addressed? Nope. They are bigger than ever. As a small example here is Spain's unemployment rate:
Or Greece's Real GDP:
Yep, all clear now. We don't really hear that much about Europe any longer. Perhaps if disaster is more than 3 or 6 months out we can just ignore it.
Lately the key source of investor angst has been guessing when the Fed will start "tapering" its bond purchases - that is buying them at a slower rate and thus decreasing the rate of monetary stimulus growth, if not the level.
I'm getting sick of the word. I'm sure Ben Bernanke wishes he never uttered it.
What I find most perplexing are the conclusions that people seem to draw about what will transpire if and when "tapering" begins. It seems the entire global economy and the markets are on a knife-edge and whether or not the Fed buys a few fewer bonds in September or December will make all the difference.
The rationale I keep hearing and reading is pretty simple, if not myopic. It basically goes something like this:
If the Fed stops buying bonds, bond prices will fall and yields will rise. Simple supply and demand. Less demand = lower prices. Pick when tapering starts and you can make money or avoid losing it.
There are huge flaws in this logic. It would be more accurate if it included one of my economics professor's favorite Latin terms, ceteris paribus, meaning "all other things being held equal". This is the problem - all other things are not held equal when the Fed is or is not in the market buying bonds.
Bonds are not widgets, gold bars, or Frappuccinos. The are pieces of paper denominated in the "instrument" that the Federal Reserve can create on a whim - dollars. To make a simple "taper = lower prices" argument, there is an inherent assumption that entire remaining part of the bond market doesn't react. They don't adjust. They don't look at what the Fed is, isn't, or might or might not do. They are a deer in the headlights waiting to get run over.
Nothing could be further from the truth - bond investors are rightly very focused on the Fed's actions. Some may just be drawing the wrong conclusions.
If the Fed were buying up every bond in existence, it could indeed control pricing all along the curve. It is not, not even close.
According to the US Treasury, the total outstanding amount of marketable treasuries as of June 2013 are shown below:
While the dates do not line up perfectly, the securities held by the Federal Reserve are shown below:
Combining the two sets of data we can show the Fed's holdings as a portion of the outstanding bonds:
Graphically by maturity it looks like this:
In aggregate, the Fed owns 17.7% of the treasuries outstanding. I'd say what they other 83.3% of holders does matters. Do holders of the other 60% of long term bonds sit there with blank stares while the Fed creates potentially inflationary (long term, which matters for long term bondholders) excess reserves? Don't bet on it.
Of course the Fed also owns approximately $1.3 Trillion in mortgage backed securities which is about 44% of the MBS's outstanding but only about 10% of the mortgage debt outstanding (data here).
In total, between treasuries, MBS's and a small amount of agency bonds, the Fed owns about $3.4 Trillion in bonds. That seems like a lot, but now let's consider that there are a vast number of corporate and other US dollar bonds out there that also react to inflation and interest rate expectations (they are just noisier because of the spread element). If rates were being artificially depressed by the Fed, surely we would see spreads blow out in similarly (AA) rated corporate bonds where the Fed doesn't pay. In fact AA corporate spreads over treasuries have barely budged and are extremely low:
Let's really put the Fed's purchases in context. According to The Securities Industry and Financial Markets Association (SIFMA), the total U.S. bond market stands at $38.6 Trillion:
That is a $38.6 Trillion market that really really cares about the future direction of interest rates and inflation. A market that trades about $800 Billion PER DAY:
The treasury market alone trades over $500 Billion per day, putting the Fed's MONTHLY purchases of about $85 Billion in context.
The reality is the bond market as a whole reacts in a rational basis, based on the outlook for future rates and inflation. Just because the Fed owns about 8.7% of the U.S. bond market doesn't mean that process will stop. The actions of the other 91.3% actually matters.
Is it at all possible that when the market sees the Fed "printing" (or more accurately creating reserves) money, it may actually view this as long term inflationary and react accordingly by actually selling bonds to adjust for those future long term inflation risks? The evidence is that they do. As this chart from Hoisington Investment Management's Second Quarter Economic Outlook (available here) shows, during QE1, QE2, and the QE-whatever we are in now, long term bond yields actually rose during each period, and fell once QE stopped (note the horribly-drawn red arrow are mine:
How many people have actually looked at this?
In my view, it's more likely that if the Fed does start to "taper", it could actually be a positive for the bond market. The wind-down of a potentially inflationary policy might (shockingly, I guess) be a positive for assets that are highly exposed to inflation risk (i.e. bonds). Unless the Fed really steps it up I don't think long term rates are artificially depressed because of QE. I think the opposite.
From my perspective as someone who invests in bonds, the sooner the Fed stops buying bonds the better. Good riddance.
While always difficult to make forecasts, it's possible that "Tapergeddon" may turn out to be a wonderful example of "sell the rumor, buy the news". Long term US bonds (and ETFs such as TLT may actually be a steal at these levels.
"Reality is wrong. Dreams are for real"
- Tupac Shakur
Additional disclosure: This article reflects my personal views only. I have a long position in TLT. All data and calculations presented are accurate to the best of my knowledge but have not been vetted, checked, proofread, or independently verified. This article should not be relied upon for any purpose other than for entertainment. I welcome comments and or corrections.