While the Fed has not yet announced plans to taper its asset purchases, the economy appears to be entering a new era for the Federal Reserve, and it raises some key questions about the future path of yields on Treasury securities. After feeling the need for extraordinary measures since 2010, despite steady, if not stellar economic growth and private sector job creation, the Federal Open Market Committee (FOMC) is grappling with when and how to exit its current quantitative easing (QE) program. At its two-day meeting in mid-September, the FOMC surprised the market and chose not to initiate any tapering of asset purchases. Still, the message was clear that if economic progress continues, then the tapering of asset purchases may be announced at its next meeting on 29-30 October or the following meeting on 17-18 December.
Reading between the lines, there were probably several reasons the Fed decided to delay tapering its QE program and defer the decision. First, there is a non-trivial chance the U.S. Congress may not be able to agree a budget resolution or raise the debt ceiling in time to avert a temporary shutdown of the Federal government. A government shutdown would clearly cause some harm to economy, and it would reinforce a general perception that the U.S. Congress is less and less able to govern effectively. Second, the Fed was probably not comfortable with all the media coverage surrounding the withdrawal of Larry Summers as a possible nominee for the next Chair of the Federal Reserve Board and wanted to buy a little time. Whatever the real reason, the all eyes will now be on the next FOMC meeting - just before Halloween.
When the Fed does start the process of exiting quantitative easing, it is likely to do so gingerly. The FOMC will probably take pains to remind market participants that its target federal funds rate may remain near zero for long after asset purchases are ended, and most likely until core inflation is rising above 2.5% and inflation expectations are no longer firmly grounded at low levels.
For the most part, the market reaction to the debate over when and how to start tapering asset purchases has been focused on Treasury yields, since it became clear in May 2013 that a QE exit plan was coming down the pike. On May 1, 2013, the U.S. Treasury 10-year Note yielded 1.68%, and it now trades in the 2.70% to 2.95% range. At the same time, volatility in the Treasury market has increased toward historically more typical levels, up from the very low levels brought about by the Fed's massive asset purchases. Interesting, and very telling, is that the S&P500 Index has moved to new highs, despite some downdrafts when the QE exit debate first started.
There are several possible scenarios for the path of yields on U.S. Treasury securities once the tapering of asset purchases starts. Our take has always been and remains that on average and over time, yields on U.S. Treasury securities will reflect inflation expectations.
Our interpretation of the last few years of purchases of U.S. Treasury securities and mortgage-backed securities by the Fed, which includes both the maturity extension program and the latest round of quantitative easing, is that the main impacts were to depress the yields on Treasuries and to lower market volatility.
Since 1960, the relationship of Treasury security yields to inflation can be roughly divided into the period of rising inflation expectations, which ended with the 1980-1982 recession, and the period of declining inflation expectations which ran from 1982 until the Great Recession in 2008. While inflation was rising in fits and starts during the 1960s and 1970s, market participants' inflation expectations tended to lag behind the actual inflation rate. But with the exception of the spike in general inflation with the first OPEC oil price shock in 1974, yields on the 10-year U.S. Treasury Note stayed above the core rate of inflation (i.e., excluding the volatile food and energy sectors). There was some uncertainty and volatility created by President Gerald Ford's "Whip Inflation Now" public relations program and President Nixon's flirtation with price controls, but in the end bond yields retained a premium on average to actual inflation, even if inflation expectations lagged behind just a little bit.
The opposite pattern occurred in the dis-inflation period starting in the 1980s, as the actual inflation rate declined faster than most market participants expected. This led to widening of the premium of Treasury yields over reported inflation in the 1980s and early 1990s. Once the actual core inflation rate settled into a more stable zone under 3%, the bond premium narrowed a little bit further. See Figure 3.
What these historical periods illustrate is that it takes something extraordinary to dislodge U.S. Treasury yields from a relatively stable relationship of offering a risk premium to inflation expectations. Price controls narrowed the premium in the early 1970s almost to zero until it became clear they did not work, were unpopular, and would be terminated. The 1974 OPEC crisis pushed general and core inflation above Treasury yields in the mid-1970s because market participants incorrectly (as it turns out) thought the first oil price spike was a temporary event. And, this time around, the Fed's maturity extension program and then massive asset purchases in 2012-2013 eliminated the inflation risk premium.
What is less well-understood is the role of the U.S. dollar in how it impacts the inflation process, both up and down. In the 1970s, the U.S. was forced to abandon the Bretton Woods fixed exchange rate system and a regime of floating exchange rates was introduced. The U.S. dollar was extremely weak against the other large industrial economies, especially Germany and Japan. U.S. dollar weakness led to what was then referred to as a vicious cycle, in which a weaker dollar led to more inflation, which led to a weaker dollar, etc. This inflation reinforcing cycle played out until President Jimmy Carter appointed Paul Volcker to lead the Fed in 1979, and Volcker took short-term rates close to 20%, weathered a tough recession period from 1980 through 1982, and broke the back of inflation in the U.S. Volcker's Fed policies also ushered in a period of rapid U.S. dollar appreciation, which created a virtuous cycle of reducing inflation, more dollar strength, less inflation, etc.
In the period after the Great Recession of 2008-2009, the central banks of the U.S., Europe, the U.K., and Japan are participants in following some form of quantitative easing. This has meant that until Japan broke out of the pack in December 2012 with the election of Prime Minister Abe, there have not been any sustained currency trends among the major players. And as a result, except for Japan in 2013, there has not been the possibility of currency moves assisting, for better or worse, the inflation process. Indeed, for the U.S., Japan's move to weaken its currency is slightly deflationary. Without the reinforcing cycle of currency movements, there has been no inflation pressure in the U.S.
While we have argued that five years of highly accommodative monetary policy may eventually lead to some inflation pressures, without a weak dollar to reinforce those pressures, inflation will be slow in coming and may be much milder than some monetarist economists might expect. Consequently, our base case scenario is that U.S. Treasury yields have already moved, in anticipation of the Fed's QE exit to a higher trading range for yields that reinstates a reasonable risk premium over current inflation. In some sense, it really makes little difference if the Fed starts its QE exit plan in November or December or even early 2014, given the market has discounted this step already. More importantly, a long-term bear market in bonds, in this interpretation, requires the emergence of sustained and persistent inflation pressure, and we see that being associated with a weak dollar, which is not the case today.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.