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April 15, 2014 - The Bond Market is Telling the Fed Not Yet! by Market Authority
If an older water pump is turned off for an extended period of time, it will lose pressure and stop working. In order to get the pump going it needs to be “primed,” meaning water needs to be manually forced through it to create enough pressure for the pump to function again.
This is where we get the economic term “priming the pump,” a Keynesian form of stimulus to get the economy moving again. Bernanke, Yellen and their merry band of pump primers actively purchase the least-risky government bonds and mortgages from financial institutions in exchange for cash. The cash that the financial institution now owns is expected to be re-invested in higher-yielding assets, allowing much-needed capital to flow through the economy. This additional capital should encourage businesses to hire and spend, and drive growth.
The latest round of pump priming, also known as Quantitative Easing 3 (QE3), commenced in September 2012. Under this stimulus program, the Fed purchased $85bln a month in treasury and mortgage bonds to get credit flowing through the pipes again. As the economy started to gradually improve, the Fed began to “taper” the $85bln of purchases per month in December 2013. After three rounds of tapering, the total amount of monthly asset purchases is now $55bln and QE3 is widely expected to disappear by October 2014.
And now investors are faced with these uncertainties: Has the Fed forced enough credit through the economy to jump start the business cycle? Can the economy now continue to grow on its own?
Another analogy is teaching your 5-year old how to ride a bike with training wheels. You gradually remove one training wheel at a time until the child is able to ride without any assistance. Eventually, the training wheels are removed and there’s a high degree of uncertainty as to whether the child is capable of riding off down the street or crashing into the neighbor’s bushes.
Right now, the US government bond market is saying, “NO.” You can see this in the shape of the US treasury yield curve.
Take a look at the curve on January 2, 2014 vs. the curve today. The first thing you should notice is the flatness out to two years. The Fed has signaled that rates will be low for the foreseeable future and the market believes them. However, for maturities past 5 years, the curve is less steep than at the beginning of the year. Longer dated bonds are rallying, even though the Fed is scaling back on asset purchases. (Yields move inversely to price, so a lower yield means that the price has gone higher.)
This should seem completely illogical. How can the value of US Treasuries move higher if the Fed is increasingly buying less of them? Shouldn’t the fact that the Fed is buying less cause prices to drop and yields to move higher?
To understand the logic of the yield curve, we must look at what it represents. The yield curve is a picture of how investors feel about the economy in the future. And these feelings are much more important than what the Fed actually buys.
A steepening yield curve is a sign that the economy is picking up and inflation expectations are rising. This is precisely why the Fed started priming the pump in the first place – to get the economy moving again. Now that the Fed is pulling back on stimulus, investors are starting to worry whether or not the Fed has done enough. This causes the curve to flatten.
Now, let’s take a look at what the curve looked like BEFORE the Fed began QE3. Here’s what today’s yield curve compares to way back in July 2012…
Today’s curve is much steeper than pre-QE3. Growth and inflation expectations are much higher now. In that sense, QE3 has worked. However, we should be concerned if the yield curve continues to flatten back to pre-QE3 levels. That would signify that the Fed removed the training wheels too soon and the neighbor’s hedge is in serious danger.
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