The financial markets have been pondering the effects of Chair Yellen’s March 19 press conference and trying to discern what the true meaning of the “six month” import of rate rises beginning at the end of the tapering process that the Fed has initiated. The move in the short-end of the yield curve has revealed what I have long thought: The middle part of the yield curve has been badly mispriced as many hedge funds and fixed income buyers have comfortably bought more term instruments in the shadow of the Fed’s massive buying program. Venturing into the valley of the three- to five-year duration has not been the “safe harbor” that many thought and the result has been a post Fed meeting massive move in the 5/30 part of the yield curve.
The move is depicted in a 12-month chart of the 5/30 (top) curve from Bloomberg. A 30-basis point move is indicative of a huge position being unwound and Bill Gross’s call for this curve to widen has gone very badly. I say Gross only because he was so open and ubiquitous in his efforts to crow about the wisdom of this trade … as long as it was working. Even with the Fed still a regular buyer of the long-end of the curve the collapse in the curve is astounding. Further proof of the massive amounts of interest in the 5/30 is the stability of the 2/10 yield curve (bottom) over the same period. The fed’s ability to cause massive dislocations in credit markets is revealed through investors mispricing risks by hiding in less volatile duration risk. NEGATIVE REAL YIELDS ARE A TREACHEROUS PLACE TO SEEK COMFORT IN TIMES OF UNCERTAINTY.Will the 2/10 curve return to its lows made last May and mirror the action of the 5/30? I don’t know as the market will need more time to discern the words of the new Fed chair.
***The flattening of the 5/30 seems to be about a position gone bad and is thus not having a major impact on the entire investment picture, but if the entire curve were to begin an aggressive tightening the impact on the overall investment situation would change dramatically. The markets are priced for more Bernanke and not a change in Fed philosophy. But I will advise paying close attention to the speech of Jeremy Stein from March 21, titled, “Incorporating Financial Stability Considerations Into A Monetary Policy Framework.” My readers know that it was Fed Governor Stein who raised the issue of the Fed’s QE programs causing the mispricing of financial assets.
Stein’s warnings were set aside after the markets met Bernanke’s talk of tapering with a selloff in the bond markets that seemed to unnerve the Fed Chairman. Jeremy Stein is back with more data to support his argument about the Fed causing the financial risk by pushing bond prices to levels that promote unacceptable levels of risk. Stein looks at “risk premium,” or what an investor “can anticipate earning in excess of that on the short-term Treasury bills.” In analyzing the risk factor involved in the bond markets Stein will choose to measure risk through “the so-called term premium, which is the expected excess return on longer-term Treasury bonds relative to short-term bills, and the credit risk premium, which is expected excess return on bonds with credit risk [for example, corporate bonds, or asset-backed securities] relative to safe securities.”
Governor Stein believes that the mispricing of risk due to monetary policy may be so important to the financial system that it supercedes the full-employment level. At this point Stein admits that his views are conjectural but believes it is important for this data to become part of the monetary policy discussion. In his conclusion he says “… CANONICAL MACRO MODELS IN THE NEW KEYNESIAN GENRE OF THE SORT THAT ARE OFTEN USED TO INFORM MONETARY POLICY TEND TO EXHIBIT LITTLE OR NO MEANINGFUL RISK PREMIUM VARIATION.” [EMPHASIS MINE] This may be the most important piece of the entire piece as Governor Stein calls the Fed’s beloved models into question. The interest rate picture is now set to become much more volatile as a powerful academic voice has been raised again at the highest level of boardroom. Be advised all you sellers of premia.
***A QUICK HITTER: the Canadian Dollar has been a poor performer as of late. It may be because it is deemed a commodity currency and is suffering in the shadow of a slowing China or because of the rise on the mid-curve rates in the U.S. In thanks to a heads up from long-time reader SM, it is important to note that provincial elections take place in Canada on April 7 and there is some fear that if the Parti Quebecois polls strongly in Quebec there may be a renewed push for a referendum on the secession of the Province from the rest of Canada. The idea of Quebec secession has plagued Canada for more than 20 years and although the issue has gotten close to passing, it has failed to become a reality. Markets punish political uncertainty so be alert to further pain for Canada until there is greater clarity on Quebec’s political situation. The Quebec Liberal Party is opposed to a referendum and has recently been shown to be gaining in the polls and is led Philippe Couillard and the Parti Quebecois led by Premier Pauline Marois, the leader of a minority government. The issue is the economy versus political sovereignty. Be alert if you trade the Canadian dollar. Watch for post from our Canadian readers for further information as the election nears.