The 10-year Treasury yield peaked at about 2.92 percent last week, up from a peak of about 2.89 the week before. The yield on 10-year TIPS rose to almost 0.78 percent in the weak up from about 0.65 in the previous week. Yields softened modestly toward the end of the week.
The other yield investors need to watch in the "risk on-risk off" game is the yield on the 10-year German bund. Last week this security closed to yield close to 1.95 percent, up about 5 basis points from the week before.
Basic conclusion: the yields in these two securities, in my mind, are still under pressure to rise, but are pausing here in late August, waiting for the fall season to unfold.
The major uncertainty of the fall is, of course, the tapering of Federal Reserve security purchases. The uncertainty is not due to a question concerning Federal Reserve tapering taking place. Almost everyone…in the world…believes that the tapering of Federal Reserve security purchases will take place this fall…and more specifically, they believe that it will begin around the middle of September.
The question marks pertain to the path the tapering will take. It seems that the "bet" right now is that the Federal Reserve will reduce its monthly purchases of Treasury securities and mortgage-backed securities from $85 billion per month to around $75 billion per month…a $10 billion per month reduction.
This is seen as only a minor "shaving" of the purchases. The objective is to see just how the market reacts to this small reduction in purchases. The hope is that incremental changes in the amount the Fed purchases every month will cause the least amount of disruption to the financial markets as possible.
If the financial markets adjust smoothly to these "small" reductions in purchases then the Fed, possibly, might increase the size of the reductions. But, this will only be determined after officials at the Fed are confident that they are not creating major disruptions.
The timing of the tapering? Tapering will begin in the middle of September. I believe that Mr. Bernanke really wants the tapering to begin while he is still the Chairman…he doesn't want his successor to have to bear the brunt of this responsibility. I also believe that Fed officials will be able to use the economic statistics that are available to them at the time to justify to themselves and to others that tapering can begin.
It seems to me, especially after some of the presentations at the Fed's annual "bash" at Jackson Hole, Wyoming, that there is sufficient evidence that this last round of quantitative easing has done little or nothing to spur on more robust economic activity and that ending the effort will do little harm to the economy…as long as no financial dislocations are caused by a Fed move to exit itself from the execution of the easing.
If there is any concern about the Fed easing it is coming from "off shore." It seems as if the major worry at the present time is that Federal Reserve tapering might cause substantial dislocations in emerging markets. See for example, the headlines in the Financial Times: "Emerging Markets Turmoil Dominates Jackson Hole Discussions."
Already exchange rate fluctuations in India, Brazil, and Indonesia have caught the attention of many and have been attributed to the expectation that the Federal Reserve will soon begin to taper. The basic feeling is that the quantitative easing of the Federal Reserve in the past has been positive for these nations as the low US interest rates that resulted provided opportunities for the carry trade, while higher exchange rates allowed governments to be extremely aggressive in pursuing domestic economic policies.
The possibility that events are now moving in the opposite direction have resulted declining values of their currencies in relation to the US dollar which will put pressure on governments to put constraints on their economies.
According to Robin Harding in the Financial Times article cited above, the impact of tapering on emerging markets "became the theme of the conference."
And, given the pain that the expectation of any Fed move to begin tapering has caused, Harding writes, "The majority view among policy makers at Jackson Hole was that there is more pain to come…."
The question that arises from this discussion is whether or not the Federal Reserve will take this possible "pain" into consideration. The answer, as can be discerned from statements made by Fed officials, is that the Federal Reserve will not let these concerns impact their decisions.
Federal Reserve officials believe that in considering tapering their goals are dominated by the objectives set out for them by the US Congress and these objectives relate to the economic health of the economy and to inflation.
Underneath this belief is the feeling that some of these countries that are "crying" now are ones that took advantage of the extraordinarily loose policies of the Federal Reserve…along with the low interest rates…and they acted in a very undisciplined manner. Consequently, it is not the responsibility of the Federal Reserve to "bail out" these nations on the other side of the action. These nations created the situation that they now face and must deal with the consequences of those actions.
In conclusion, I would argue that the Federal Reserve will begin to "taper" security purchases in September. The tapering will be modest at first, because Fed officials want to see how the financial markets respond. My belief is that financial markets will respond moderately to these reductions and that tapering will go along smoothly. I believe that the extraordinary purchases of securities connected with QE3 will end sometime in spring of 2014.
My own view is that the sooner we get back to more "normal" Federal Reserve operations the better.
In terms of the future of longer-term interest rates I believe that they will continue to rise throughout the rest of 2013 and into 2014. As I have written earlier, I believe that yield on the 10-year Treasury security will rise into the 3.00 percent to 3.50 percent range and will be closer to 3.50 percent than to 3.00 percent in most of 2014. My view is that this is where longer-term yields should be given the current economic conditions and the state of United States inflation. Given this, I also believe that the yield on the 10-year TIPS will move up to around the 1.50 percent level.
This, of course, I would expect to happen if the economic recovery continues to take place in Europe and European financial markets stay calm, and if there is no major conflict with Syria and if China's economic expansion remains in place and so on and so forth.