by Ivan Martchev | June 10, 2013 8:00 am
May was a strange month for Treasury investors. The benchmark 10-year T-Note yield hit a year-to-date low of 1.61% on May 1. Then on May 31, after a sharp reversal, the benchmark yield hit a fresh annual high of 2.21%.
And some bond investors think there is more room for surging rates given recent Fed statements.
The ammunition for the bond vigilantes came from Fed Chairman Ben Bernanke himself on May 22 in the Q&A session of his Congressional testimony: “If we see continued improvement, and we have confidence that that is going to be sustained, in the next few meetings we could take a step down in our pace of purchases.” That was all the market seized upon from an otherwise lengthy and balanced testimony.
To me, this is far from a definitive tightening statement, but sometimes investors hear what they want to hear, and they don’t dwell on nuances or weigh the chairman’s words in context. But rather than read the tea leaves, I decided to call up a familiar bond expert with the momentous question: “What happens when QE ends?”
Mike Lanier, who has traded bonds for some of the nation’s largest financial institutions for more than two decades, took 90 minutes to give me an answer, and in the end he was still far from certain. This was the conversation that ensued.
“It is unlikely that QE stops at the flip of a switch given that the Fed is the biggest buyer of Treasuries,” Lanier told me. “Such an act would be very disruptive, and the most likely scenario is that the Fed pulls back very slowly over time. Right now we still are in a trillion-dollar deficit situation, so any premature tightening can kill the recovery. Those federal tax receipts look pretty good for 2013, but this is an illusion. The rate of growth in entitlements is completely out of control, guaranteeing exploding federal spending over time if not arrested.
“To boot, the large deficit at present is funded with short-term bills and notes. The average maturity of federal government debt is 65 months at present. The five-year note yield is 1.05% at present, while at the 2013 low it was 0.65% (both below the rate of inflation of 1.1%). This makes federal government funding technically free when adjusted for inflation. Any sharp rise in interest rates will blow up the federal budget as the federal debt burden now stands at $16.43 trillion. As you can see, this QE business is not going to be ended quickly.”
I still wanted to hear how the end of QE might affect the corporate bond market, even though it was likely a process and not an event.
“Naturally, if the biggest buyer in the Treasury market pulls back, long-term rates should go up,” Lanier said. “Even though a stronger economy should result in less issuance of Treasury debt, growth in entitlements will result in more spending down the road, so the deficit is a long-term issue. You can see what a hint of QE tapering did to government yields globally.
“Typically, when Treasury yields are going up because of a strong economy, there is room for contraction of credit spreads. The bigger the credit spread to Treasuries — like BBB, BB and B bonds — the less sensitivity there is to rising rates. With junk bonds, though — BB and lower — you have to worry about credit risk, which becomes a real problem if the economy weakens again. There is very little room for contraction in spreads to Treasuries in the higher grades, like AA bonds for example, where spreads are already below historic norms. There, the interest risk is high.”
“How do you mean high interest-rate risk?” I asked.
“A sharp rise in long-term Treasury rates re-prices all longer-term bonds that have tight credit spreads to Treasuries, as there is little room for contraction in the credit spread,” Lanier said. “The longer the maturity of the bond, the more sensitive its price is to a rise in long-term rates, also increasing notably with bonds issued today with low coupons. There is very high duration risk in the market right now.”
(I looked for examples of Treasury ETFs with high duration risk and I found two: the PIMCO 20+ Year Zero Coupon U.S. Treasury Index Fund [ZROZ] and the Vanguard Extended Duration ETF [EDV].)
“Given that there is no real precedent for this QE maneuver,” Lanier continued, “we can only theorize how it will affect different types of corporate bonds. It seems to me that the best place to be in the bond market is in intermediate-term corporates of medium quality. This is because there is very little yield in short-term bonds due to the Federal Reserve’s near-zero-interest-rate policy and because their price is so much less sensitive than long-maturity bonds, as a normalization of long-term interest rates is coming sooner or later. If you are investing for yield in corporate bonds, you need intermediate-term bonds that have some spread to Treasuries (read: cushion), but also a manageable level of credit risk.”
“Quantitative easing is simply buying time,” Lanier concluded. “The government has to fix the spending problem as quantitative easing cannot continue indefinitely. There is only so much excess reserves the Fed can stick the banking system with — $1.75 trillion at present — to help it fund a $3.4 trillion balance sheet. Everyone is getting understandably nervous.” (We have seen political statements with increasing degree of alarm from the major dollar reserve holders like the BRIC countries, as they hold $4.4 trillion in forex reserves.)
This whole conversation reminded me of a graduate school finance professor of mine, who in the discussion of yield curves and Fed policy always liked to mention that the Federal Reserve chairman, in his opinion, had more power over the U.S. economy than the President of the United States. Since his power was felt through channels not well-understood by the general public, the Fed chairman was only revered by those in the field of finance.
I did not appreciate this power argument at the time. But given how the role of the U.S. central bank has changed and its level of intervention in financial markets has dramatically increased in the past five years, I have to say I understand the argument a lot better now.
But I wonder: Why does all this power concentrated in the position of the Fed chairman go to an unelected official?
Ivan Martchev is a research consultant with institutional money manager Navellier and Associates. The opinions expressed are his own. Navellier and Associates does not hold positions in any stocks mentioned for its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the above mentioned securities.
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