End to Quantitative Easing?

In the past year the financial markets have set many new Guinness Book of Record levels. ‘The biggest one day drop’, ‘the largest one months gain’, ‘the lowest interest rate’, the ‘highest volatility’. It is already a pretty impressive list of firsts. We are in the process of setting another of those records. The steepness in the yield curve is about to set a new record. Not since 1992 have we experienced the levels that the market now finds itself at.

In 92 the two-year ten-year spread reached 262BP. At that time short rates were at 4.25% and the ten-year at 7%. Today the 2’s / 10’s rates are .97% and 3.72% respectively. In 92 the economy grew at 4%. The prevailing economic conditions as well as the general level of rates at that time gives us few clues to what may happen in today’s bond market. Those rich bond yields and the steep slope went away in the years that followed. For an extended period of time thereafter the yield curve was actually inverted.

The visible bond supply by Treasury is the biggest factor today. The Treasury has offered up $500billion in new paper per quarter for the last nine months. The future calendar is also very heavy. The forecast is for an additional $900 billion of new borrowings in the coming six months. The market understands that those forecasts understate the actual borrowing to come. It is easy to see why we have indigestion.

The next problem for the bond market is all these green shoots that DC and Wall Street keep seeing. Who in there right mind would want to buy a bond at 3.7% when after tax that will be a loser versus inflation?

Those issues have been in the market for quite a while. It is hard to explain a 150 BP rise in rates over two months based on things we knew about. Other factors are weighing on the bond market.

-You can’t get short. The market provides us plenty of options to get short. All those alternatives just cost a fortune. Shorting the bond using standard 20 to one leverage produce a negative carry of 40% per annum. If you are a day trader or a bond dealer you can be short and make money. But longer term this negative carry is a wall to climb so there are few strategic shorts out there.

-Someone in mortgage land is leaning on the market in an effort to extend their average liabilities. Both Fannie Mae and Freddie Mac publish a monthly report that measures their funding gap. They proudly report every month their book of assets and liabilities are roughly balanced. This is a bad measuring metric. It forces the Agencies to seek ‘convexity’ when interest rates change significantly in a short period of time. Collectively they have spent hundreds of billions in derivative costs over the past ten years. Historically they have come into the market and bought high and sold low. It would be interesting to confirm if either Fannie or Freddie were contributing to the mayhem in the market these past few days. If they were, it would be a slap in the face of Mr. Geithner who is trying to sell a 100 billion of bonds this week. My guess is that the Agencies were involved.

-The bond market does not know what to make of ‘quantitative easing’. After all, this concept has been with us for a very short period of time. The Fed has committed to buy up to 1.7 trillion of MBS and Treasuries. The knee jerk reaction to this was, “Wow, with this much demand rates are going to stay low forever!” A mere sixty days later that has turned into, “They are running the printing presses 24/7. Massive inflation is sure to follow”.

Quantitative easing was an important step in stopping the slide in the economy last fall. It was an emergency measure. The emergency is over. Quantitative easing is now problem, it is no longer a solution.

It is extremely unlikely that the Fed will recognize this reality in the near term. It is more likely that they will vote to expand their purchases of government securities as was indicated in the Fed’s recent minutes. Mr. Bernanke actually believes that he can control the market. This observer believes that he is in for a rude awakening.

When forecasting interest rates there are normally three possibilities. Either rates can remain stable or the can go up or down. Today there are only two possibilities. Rates can remain stable or the can go up. There is no risk that they will go down. In the short run it is possible that the rapid run up in rates in the last two months will result in a few months of relative stability. However rates are going to have to move significantly higher by the end of this year. My guess is that the next leg up will happen in September. If I am wrong it will happen by the end of the month. Either way those green shoots will turn brown by autumn.