The minutes from the last Federal Reserve meeting were released on Wednesday. Often, the reaction to an event is more important than the event itself. Interestingly, the 5-year yield made a subtle upside breakout. As the tapering debate continues to drive up bond yields, it is worth focusing on the debate on forward guidance, which could be the next big catalyst. In this article, I will update my view on Treasury bonds and highlight the important messages from the Fed minutes.
Treasury Bond Yields
The yield on the 10-year is continuing its upside breakout and reached 2.90% today. In the short term, the 10-year could test the psychologically important 3% level. Further out, it looks like the 10-year could continue to rise to 3.5-4.0%.
Please remember that as bond yields rise, bond prices fall. Also, in the charts below 29.01, represents a yield of 2.901%, just move the decimal point one place to the left.
Today, the yield on the 5-year broke out of its recent range to the upside. Shorter-term bonds are more tied to the Fed Funds Rate. The Fed has insisted that it will keep the Fed Funds Rate at a low level for a long time. Therefore, the upside move on the 5-year is important because it indicates that shorter-term bonds may be confirming the upside move in the yield of the 10-year and longer-term bonds. More time is needed to determine if the breakout in the 5-year is real, but it is worth watching closely.
The iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) is the widely used proxy for the price of longer-dated Treasury bonds. Its price falls as bond yields rise:
Fed Minutes: The Big Picture
In May, the Fed started to publicly discuss tapering (reducing) its $85 billion of monthly bond purchases, called quantitative easing (see Appendix I for the timeline and sources).
Since then, bond yields have shot up, as the charts above show.
The pig picture is that the Fed is going to start tapering at some point and it is becoming increasingly vocal, and detailed, about its plans. The decision on tapering is data dependent and we don't know when the data will be good enough to trigger the tapering. Clearly, bond yields have already started to react to the concept of tapering. The tapering may start in September or later, but the bond market has been reacting for weeks.
Here is a link to the documents pertaining to the July 30-31 Fed meeting:
The Fed Is Manufacturing Uncertainty
In addition to printing money, the Fed is printing uncertainty and markets hate uncertainty. There is uncertainty about the timing and size of tapering. There is uncertainty about the eventual raising of interest rates (not connected to tapering and still years away). There is uncertainty that the market (and the economy) can handle tapering.
I don't see how this uncertainty is good for the bond market (or stocks).
The Real Debate Is Not About Tapering
I take it as a given that the Fed will taper in the next few months. I don't know if it will happen at the September meeting or later, but the FOMC members themselves may not know.
However, there is another debate starting to emerge at the Fed. This debate relates to the forward guidance about raising the Fed Funds Rate.
Here is the context. The Fed is using two policy tools to try and help the economy: asset purchases ($85 billion of monthly bond buying) and forward guidance (the statement that it will keep the Fed Funds Rate low until unemployment drops).
There is some talk about the Fed altering its forward guidance in a manner that would be perceived as dovish. Currently, the forward guidance consists of the following statement:
"The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently 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, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored." (Source: Fed statement, see link above, bold added by the author)
The threshold for potentially raising interest rates is 6.5% unemployment, subject to the inflation rate.
The minutes explained the debate within the Fed about potentially lowering this threshold:
"Finally, the potential for clarifying or strengthening the Committee's forward guidance for the federal funds rate was discussed. In general, there was support for maintaining the current numerical thresholds in the forward guidance. A few participants expressed concern that a decision to lower the unemployment threshold could potentially lead the public to view the unemployment threshold as a policy variable that could not only be moved down but also up, thereby calling into question the credibility of the thresholds and undermining their effectiveness. Nonetheless, several participants were willing to contemplate lowering the unemployment threshold if additional accommodation were to become necessary or if the Committee wanted to adjust the mix of policy tools used to provide the appropriate level of accommodation. A number of participants also remarked on the possible usefulness of providing additional information on the Committee's intentions regarding adjustments to the federal funds rate after the 6½ percent unemployment rate threshold was reached, in order to strengthen or clarify the Committee's forward guidance. One participant suggested that the Committee could announce an additional, lower set of thresholds for inflation and unemployment; another indicated that the Committee could provide guidance stating that it would not raise its target for the federal funds rate if the inflation rate was expected to run below a given level at a specific horizon. The latter enhancement to the forward guidance might be seen as reinforcing the message that the Committee was willing to defend its longer-term inflation goal from below as well as from above." (Source: Fed minutes, see link above, bold added by author).
This is an important, and overlooked, debate. The discussion of tapering over the last few months has driven up bond yields. I don't think the actual tapering (in September or later) will be a catalyst for lower yields. Tapering may end the rise in bond yields, but it seems less likely that tapering will drive down bond yields.
By contrast, the potential change of forward guidance (lowering the unemployment threshold) would likely be seen as dovish and may act as a catalyst for driving down bond yields. A lower threshold for the unemployment rate would mean that the Fed Funds Rate would stay lower for longer. If that happens, the current rise in bond yields may reverse.
The forward guidance debate could be an under-the-radar catalyst.
Bond yields are rising. I am focusing on the upside breakout in the yield on the 5-year Treasury to see if it holds. Also, as long as the 10-year stays above 2.75%, I assume that it will continue to rise. The next stop looks like 3% for the 10-year.
Parsing the minutes for clues about the timing of tapering is missing the point. Tapering will happen and the timing (September or later) doesn't matter much for bonds. The Fed is printing uncertainty and the market hates that.
The important debate to watch (that is currently overlooked) is about forward guidance. It could develop into a catalyst to end the rise in bond yields, or even cause them to drop. This potential catalyst is still a few steps away, but it is worth monitoring.
The following is a timeline of key events impacting bond prices since the tapering discussion began in May:
Tapering discussion begins:
- 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
Fed meeting on July 30-31:
- July 31 - The post meeting statement was perceived as slightly dovish because the statement highlight the risks of low inflation and described economic growth as "modest" instead of "moderate" as in the previous statement (source: ANALYST: The Fed Edged Away From A September Taper In Today's FOMC Statement)
The post-meeting speeches by Fed officials focused on tapering, but it is not clear there is a consensus about tapering in September. Please note that each of the Fed officials presents his or her own opinion and not the consensus of the committee. These comments from Fed officials were mostly in-line with their previous statements:
- August 5 - Fisher Says Jobs Data Moves Fed Closer to Scaling Back QE3
- August 6 - Fed's Evans Says Tapering "Quite Likely" This Year, Yields Fall From Highs
- August 7 - Fed's Pianalto Ready To Taper If Labor Market Stays on Current Path
- August 13 - Fed's Lockhart: September Taper Not A Given; 'A Cautious First Step'
- August 15 - Fed's Bullard Floats Idea of Small Cuts to Bond Buying
Catalyst for 10-year yield to break above 2.75%:
Release of minutes from July 31 Fed meeting:
- August 21 - Fed Stays the Course on Bond Buying (WSJ)
- August 21 - FOMC Minutes Show Broad Support for Tapering Timeline (Bloomberg)
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