If you have even glanced occasionally at the financial markets over the past few months, you are undoubtedly aware of the fact that the U.S. Federal Reserve has embarked on a new program designed to promote growth in the economy. Dubbed QE2, the Fed’s program of “quantitative easing” goes into the open market to buy approximately $75 billion in bonds each month in order to try and stimulate growth in the economy.
To the average investor, this may not be completely intuitive. However, there are many moving parts to this strategy, not the least of which is the idea that such a move by Ben Bernanke’s bunch would boost confidence and, in turn, help promote economic activity.
In light of the fact that the Federal Reserve’s primary weapon to employ in its battles is monetary policy, it is not surprising that a great many analysts believe the primary goal of the QE2 program is to keep interest rates low or to push them lower. While I do not fall into this camp, the thinking is that if the Fed can push down longer-term rates via the outright purchase of bonds in the open market, then there will be more incentive for banks to lend and for both consumers and businesses to borrow.
But given that the exact opposite has occurred, there are a great many who have felt it their public duty to point out that the Fed is failing. Point number one in their attack on Gentle Ben’s plan to buy up $600 billion in bonds is that yields in the bond market have gone UP as opposed to down.
One peek at the chart below tells the whole story as the yield on the 10-year T-Note has gone from a low of 2.38% on October 8th to 3.455% as of Tuesday’s close.
10-Year T-Note Yields - Last 3 Months
In case you don’t follow the bond market to any great degree, make no mistake about it; this is a massive move. In short, yields have jumped a mind-boggling 44.75% in just over two months time. Thus, the question of the day is simple: Why have rates gone up SO MUCH even when the Fed is in the market buying bonds every month?
The talking heads and the popular press have their answers. To be fair, most of the reasons being offered up are indeed reasonable explanations as to why rates would be rising right now. But the bottom line is I think they’ve got it wrong or, at the very least, are focused on the wrong thing.
Before I summarily dismiss the fundamental explanations for the rise in yields, let’s take a moment to run through the list. First and foremost is the idea that the economy is improving. We review each and every important economic report and we can attest to the fact that the data has been coming in above expectations. As a result, forecasts for economic growth are on the rise. For example, on Tuesday Morgan Stanley upped its Q4 GDP forecast to 3.5% from 3.0%. And they aren’t the only ones hiking the numbers.
Next is the idea that risk premiums are being taken out of bond prices. No, we’re not talking about risk of sovereign debt default here, but rather the risk of recession. And anyone who has been paying attention knows that this risk has all but disappeared over the past couple of months. As such, the removal of this premium causes bond prices to fall and yields to rise.
Then there is the expectation of inflation. Bond traders don’t have too much to worry about other than the risks of default and inflation. And with an improving economy comes the expectation that inflation will pick up. Thus, bond prices are “corrected” downward in order to reflect the growing risk of higher prices in the future.
The problem with any or all of the above is the fact that none of them explains why rates have gone up SO FAR, SO FAST. As such, I believe there is a much better and believe it or not, a much simpler explanation.
Although I am quite sure that the big-picture reasons cited above are indeed playing a role in the bond market, this situation reminds me of the definition of inflation taught in every Econ 101 class: Too many dollars chasing too few goods. Only in this case we have to turn the formula upside down in order to come with the reason bond yields are soaring – Too many investors selling bonds at the same time.
When the rumors of QE2 first started flowing in late summer, aggressive traders quickly jumped in and “shook hands with the government” by buying what the government was talking about buying in the future. As a result, total U.S. government bond holdings at hedge funds soared.
According to Greenwich & Associates, as of the end of August, hedge fund managers accounted for fully 20% of the daily trading volume in the $10 trillion (yep, that’s a “t”) U.S. Government Bond market. While 20% may not sound like a large percentage, the fact that the “hedgies” only made up 3% of the bond market in 2009 puts the size of this shift into perspective.
In other words, with the Fed talking about buying a big slug of bonds, traders wanted to beat them to the punch by buying before the program started.
The Financial Times reported on August 29th that hedge funds are “diving into the bond market in order to take advantage of growing volatility and pricing inefficiencies arising from the Federal Reserve’s unorthodox monetary policies.”
In short, during the late summer, hedge funds were “buying the rumor” that the Fed was going to buy up a boatload of bonds and they all wanted to be there when it happened. But now that the Fed has begun the QE2 program it is apparently time to “sell the news.”
To be sure, hedge fund managers aren’t stupid. However, there does seem to be a rather large herd mentality among the group when big trades such as this one are concerned. And now that even amateur economists can see that the economy is improving and everyone and their grandmother is saying that it is time to “sell bonds and buy stocks,” no one wants to be caught with an oversized amount of government bonds on their books going into 2011.
In case the point isn’t obvious, I’m of the mind that we’ve got a severe case of “window undressing” going on here. In other words, someone has yelled “fire” in the crowded bond theater and traders are rushing to the exits in order to close out this trade before the end of the year.
To be clear, this is simply my opinion. But I honestly don’t see any other fundamental reason for bond yields to spike the way they are now. So I, for one, am going to simply blame it on the hedgies.
30-Year T-Bond Yield - Last 3 Months
Disclosure: No positions