We've now had a few weeks to digest the Fed's statement that it is thinking of removing the QE program. Let's take a step back and get an idea of what has happened. The biggest move has come in the fixed-income markets. As the Financial Times has noted, we've seen a huge sell-off in bonds from both central banks and investors at large:
Holdings of U.S. Treasuries held at the Fed on behalf of official foreign institutions dropped a record $32.4 billion to $2.93 trillion, eclipsing the prior mark of $24 billionn in August 2007. It was the third week of outflows in the past four.
Private investors are also dumping fixed income. Bond funds tracked by EPFR Global, a data provider, saw total redemptions of $23.3 billion in the week to June 26. U.S. funds were the worst hit, with withdrawals totaling $10.6 billion, but emerging market debt funds also saw record redemptions of $5.6 billion.
This is to be expected as the Fed has essentially placed a permanent floor in the bond market for the last three years. At the same time, it's important to ask if the sell-off is overdone. The Fed hasn't started to taper yet. And a careful reading of its statement indicates that it may not even do it if the economy slows too much. Read in light of last week's downgrade of U.S. growth for the first quarter, it's entirely likely that the Fed's plans may already be put on hold. Also, remember that the Fed will continue to reinvest principal payments as they come due.
At the same time, let's also remember that Treasury rates are at historic lows, as shown on this chart from the St. Louis Fed:
Since the beginning of the 1980, we've had a permanent rally in the fixed-income market, essentially taking rates as low as they can conceivably go. So at some point, we have to expect the process to reverse. But just how much of a sell-off can we expect? Not much, for three reasons.
First, inflation is non-existent. Here is a chart of the year-over-year percentage change in total and core CPI:
Both core and total inflation are running below 2% on a year-over-basis. With commodity prices under control, China slowing, and the EU in a depression, it's highly doubtful we'll see massive price spikes in the near future. (In fact, we could probably use a little more inflation).
Second, the U.S. population is getting older. The most commonly stated fact to support this statement is that, thanks to the baby boomers, we're seeing 10,000 people retire per day. As people get older, their investment strategy becomes more conservative, hence an increase in bond market purchases.
Third, there's still a tremendous amount of uncertainly out there. While it appears that China has averted a credit crunch for now, its central bank is clearly clamping down on the shadow-lending business, which will further clow Chinese growth. The Chinese slowdown, in turn, is negatively impacting raw materials exporters like Australia and Latin America. The U.S. is certainly not setting any growth records and Brazil, India, and Russia are facing their own set of difficulties. Put more generically, this is an environment where having a percentage of a portfolio yielding 2.5%-3% is an attractive feature.
While an uptick in yields was bound to happen eventually (and is obviously happening now), the above three reasons should limit the upside increase.