Fed Targets More Treasury Purchases. So Why The Sell-off in Bonds?

By Walter Kurtz, Sober Look

The Fed has announced that in addition to the $40 billion of monthly MBS purchases, it will also commence $45 billion in treasury purchases. This unprecedented open-ended program will swell bank reserves and ratchet up the monetary base.

The announcement of this new asset purchase program should be a big positive for treasuries, right? Turns out that it wasn’t. Longer dated treasuries rallied immediately after the announcement, but sold off shortly after, now trading at the lows for the week (see charts below).

With the FOMC doves running the show, the Fed announced it would target a specific combination of unemployment and short-term inflation expectations.

Bloomberg: – Thirty-year yields reached a one-month high after the Federal Open Market Committee said interest rates will stay low “at least as long” as the jobless rate stays above 6.5 percent and inflation “between one and two years ahead” is at no more than 2.5 percent.

The two-year inflation expectation (the so-called breakeven rate) however now stands at about 1.3% – which means the Fed has given itself quite a bit of room to get to 2.5%. And that was the reason for the selloff – such an open-ended policy clearly runs inflation risks.

Bloomberg: – “The Fed is losing some of its credibility as an inflation fighter,” said Gary Pollack, who helps manage $12 billion as head of fixed-income trading at Deutsche Bank AG’s Private Wealth Management unit in New York. “They will allow inflation to go above the long-term target. That’s disappointing for the market.”

10y note futures (source: Barchart.com)

30y bond futures (source: Barchart.com)

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Sober Look

Sober Look

Sober Look was founded by Walter Kurtz, a New York based hedge fund manager and credit markets specialist.

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Comments

  1. I agree. But in the current time the Fed says to keep the main interest rate near zero until 2015. It means that there will be no new UST with higher coupons than today until then. Therefore I should hold on my existing bonds, as the demand would arise for the outstanding bonds. Am I right?

  2. i would argue that the fed could have done the opposite of what they intended.

    it sounds crazy but over the long term they might have increased uncertainty.

    the way rate hikes used to be was leaking to the press and changing the language in the statement 1-2 meetings before the actual rate change. the market could deal with that.

    but now that you have clear targets – when is the right time to sell?
    certainly not at 6.5%. markets will anticipate long before, as they always do. so when do you sell? at 6.8%, 7% or what? nobody wants to be last in line when it comes to a potential turn in a 30year cycle.

    (look what is happening to AAPL. they are hitting on all cylinders. still the market is already pricing in margin compression and slower growth that will probably occur in 2014.)

    another point i´d like to mention is that the market might suddenly have remembered that the fed is sitting on trillions of bonds that are about to be sold into the market once the tightening cycle starts. we just don´t know how this will affect interest rates. the best guess is that fed selling would accelerate losses in treasuries.

    would love to read Cullens thoughts on that issue.

  3. addition: if you think through the outlined scenario (when to sell?) then we could also see a conundrum, that the market is starting to tighten (lets say at 7% or even earlier, maybe right now) at the long end while the fed will stay at zero, because we don´t see 6.5%.

    and it gets even more confusing when that long end tightening leads to renewed economic weakness.

    ->if my theory is correct then we could see the market to price in this uncertainty (not about the Fed, but about the markets anticipation) by including a premium of x basis points in long term treasury rates.
    i wouldn´t be surprised if rates go up a bit more and don´t react accordingly to weaker economic data.

  4. Technically, bonds are at a very difficult juncture. A minor decline would technically make gold explode, and bonds enter a severe bear market. Since mid September, bonds have been sitting on a cliff. However, the recent correction of gold has provided a breather.

    But a minor decline might imply “game over” for bonds and might signal a substantial move for gold

    http://www.dowtheoryinvestment.com/2012/10/dow-theory-spells-trouble-for-bonds.html

    Regards

  5. I agree (I think). The Fed has now given a set of conditions where it would stop buying (and even begin to sell) Treasury bonds. Although the conditions are somewhat unlikely, they are still more concrete than the open-ended criterion-less mandate the Fed had given itself. Therefore, one ought to try in some degree to get in front of a Fed unwinding.

  6. I like the analysis BUT we need to take it farther.
    The TIPS yield rose as well. why are TIPS rising if the rise in yields was inflation fears? That is what I am confused about. Break even inflation rose very little at the 10 year maturity. so the rise in yields was largely real.

  7. I disagree with the premise of the article that the reason for the selloff was due to increased inflation risks. IMHO, the real reason for the selloff was due to the major change in short rate policy. Long-term rates are ultimately a function of short rates. Previously, the Fed had said that they wouldn’t raise short rates until 2015. Now they will raise them if the unemployment rate drops below 6.5%, which will likely be before 2015. We might even be approaching 6.5% next year if Mr. Sector Balance (Hantzius at GS ) is right. So short rates could start rising a full 2 YEARS earlier than previously expected.

  8. Cullen,
    Look at the TIPS yields. something important is happening, I think. We need to figure out what it is.

  9. I don’t understand the worry about inflation (due to the Fed’s asset buying). All this is being done in the realm of reserves, which is to say spread sheets and computer keystrokes, points if you will, and the Fed is not adding any spendable money to the money supply. MMT and others have shown time and time again there is no correlation between the monetary base and the M2 money supply.

  10. You should look at 2yr forward inflation breakevens, not at 2yr breakevens, to determine what the market is pricing in for inflation. And they are at least 50bps higher than Fed’s target. Also they tweaked the buckets for buying USTreasuries from 6-30yr to 4-30yr. No wonder the curve bear steepened. It was more for these reasons, I believe, that USTreasuries sold off.

  11. The Bernank has stated that monetary policy is a flacid tool and cannot accomplish what needs to be done.

    He also stated that only fiscal policy can solve the current (balance sheet) problem but clearly the political winds will act to decrease current fiscal stimulus (revenue increases coupled with spending cuts). This can ONLY lead to DEFLATION.

    So the Fed is doing everything in its power to push inflation. It is a last gasp effort and for now the markets believe it will succeed.

    Bet against this effort – it is a fat pitch!

  12. FedZero, alone with their QEs are all about balance sheet cleaning..

    Over $900 billion (MBS) has been removed from banks portfolio, in exchange for a merely 25 BPs…LOL

    The only question, what will happen to the Central Bank balance sheets and how large will be their (insert we & us) losses.?