Bondholder Alert: Fed Runs Out Of Gas And Wall Street Takes Over

Includes: BND
by: John Tobey, CFA

Picture of gas guage on emptyThe Fed admits its loss of control in Fed's Stein Sees Risks for Credit Markets.

Federal Reserve Board Governor Jeremy Stein said there isn't an imminent threat to the wider financial system, but highlighted several markets-including junk bonds, mortgage real-estate investment trusts and commercial banks' securities holdings-as areas where potentially troubling developments are emerging, possibly as a result of the Fed's easy-money policies.

Mr. Stein's comments are significant because they are among the strongest from a Fed official about risks developing in bond markets in the presence of low interest rates and because he raises the prospect that the Fed might, down the road, need to use tighter credit policies to deal with it.

Forget 6.5% unemployment and high inflation. The real kill-switch for the Fed's policies is the law of unintended consequences, and it's been flipped. And it's not just those areas that Fed Governor Stein mentions. Wall Street has taken control of the very heart of the Fed's machine: U.S. Treasury bonds. Want to know what's going to happen next? Ignore the Fed and watch Wall Street.

Reason #1 to ignore the Fed: Abnormality

The Fed's portfolio is radically abnormal - in both size and maturity. These two graphs show five normal years (2003-2007) and the abnormal crisis and post-crisis periods. (The assets shown, accounting for most of the Fed's portfolio, are from the Fed's market buys and sells, not special programs like TARP.) The first graph shows the huge growth in assets; the second, the dramatic shift in allocation from short-term to long-term securities.



(Data source: Federal Reserve Bank of St. Louis - FRED)

These graphs are a reminder of how far beyond normal the Fed's portfolio is. Wall Street sees that the day of reckoning (i.e., the Fed's having to liquidate and return to normal) is closing in. Since Wall Street acts in anticipation of facts, yields are rising now as gains are taken and new positions are established. The goal: To profit as yields rise back to normal, aided (exacerbated?) by the Fed's unwinding of their huge long-term bond holdings.

Reason #2 to ignore the Fed: Fear has diminished

Reason #3 to ignore the Fed: Reality rebuffs Fed's belief in long-term rate control

A long-held belief has been that the Fed cannot control long-term rates. Through management of money supply and bank reserves, Fed actions can affect short-term rates. However, the Fed is up against investment valuations when it enters the long-term bond arena. There are too many factors (e.g., inflation outlook) that affect long yields besides the Fed's reducing (temporarily) the supply of long bonds.

Nevertheless, this Fed attempted to drive those long-term rates down and, seemingly, was successful. So, how come the Fed's actions seemed to work until recently? Fear and incorrect analysis.

Two graphs show that it was the correlation among periods of fear, Fed actions and interest rate moves that kept alive the idea that the Fed was having an effect. However, a closer look shows that the correlation actually disproves the notion.

First, look at the long-term bond growth and the timing of interest rate declines and rises. Those declines occurred not when the Fed was buying (increasing their holdings), but when a mega-fear period was hitting investors and causing the stock market to drop (driving investors to bonds). Conversely, during the Fed-action periods, rates tended to stop declining and even rise somewhat.

Next, look at the timing of the Fed's programs: They were introduced after the mega-fear period was over. In other words, the Fed used those fears to argue that they needed to do something, even though rates had already dropped. Now look at 2012's two, milder worry periods. The first had a drop in rates, but the second did not. Fairly clearly, the fear effect dissipated last year. Nevertheless, the Fed warned that it needed to take further action, hence QE-3 was initiated. However, the lack of fear along with Wall Street's skepticism led to long-term yields continuing to rise.



(Data source: Federal Reserve Bank of St. Louis - FRED)

The bottom line

The Fed's inability to control long-term rates has once again been proven, and Wall Street is back in the driver's seat. Importantly, what the Street sees is not inordinate risk, but continuing economic growth, burgeoning investor interest in stocks, and, beneath it all, the Fed's bloated long-term bond holdings that need to be sold.

For bondholders, it's time to reevaluate holdings. Are you holding a bond to maturity to fulfill a future cash need, or to be part of a laddered portfolio? Or have you stretched your bond maturity risk (and/or credit risk) in order to pick up a bit more yield? It's that latter strategy that is now most at risk - as Fed Governor Stein has warned.

Disclosure: Long U.S. stocks I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.