When the minutes of the Federal Open Market Committee meeting in January were published on February 20, anxious bond traders searched for any change to the tone from the minutes of the December meeting, when the Fed had first confirmed that “several members thought that it would probably be appropriate to slow or stop [asset] purchases well before the end of 2013, citing concerns about financial stability”.
The publication of the December minutes led to a big Treasury sell off in January as the realization dawned that the end of quantitative easing (QE) could come sooner than many had assumed.
Following that, earlier this month, bond traders had to digest a speech by Federal Reserve Board governor Jeremy Stein on the contribution of monetary policy to episodes of overheating in the credit markets.
Stein reflected on signs of investors over-stretching for yield during a prolonged period of record low interest rates and how, if such conditions persist, the Fed might launch a monetary policy response because “changes in rates may reach into corners of the market that supervision and regulation cannot”.
Now came news from the January meeting that while “several participants stressed the economic and social costs of high unemployment, as well as the potential for negative effects on the economy’s longer-term path of a prolonged period of underutilization of resources, however, many participants also expressed some concerns about potential costs and risks arising from further asset purchases”.
Like a Kremlinologist parsing the latest pronouncement, Mansoor Mohi-uddin, managing director and head of foreign exchange strategy at UBS macro research, draws a big message from this delicate linguistic balancing between “several” doves supporting continued QE and “many” hawks now edging towards an earlier exit.
The several were the outliers in the December meetings – now they appear to be the consensus at the inner core of Fed thinking. According to Mohi-uddin, the latest minutes “show the balance of power is starting to shift away from those officials who advocate ‘open-ended’ quantitative easing”.
He adds: “What’s also significant here is that anxiety over the Fed’s current policies isn’t being driven by traditional worries about inflation. Instead, they reflect an important shift towards more concern that loose monetary conditions may risk financial instability in future.”
In its March edition, Euromoney covers in depth these gathering fears over a turn in the interest rate cycle and the potential for a punishing bond market sell-off.
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| Andrew Morton, global head of rates, Citi |
Andrew Morton, global head of rates at Citi, tells Euromoney: “There are a lot of smart people at the Federal Reserve who will be trying to model the effects of their own actions. But mortgages are where they are because the Fed is buying them. Long Treasury rates are probably 100 basis points lower than they otherwise would be because of Fed buying. When the sole buyer responsible for 100bp of lower yield stops buying ... then what? This is a completely different exit situation from 1993-94, when the Fed shifted from lowering short rates to raising them.” As fears grow that the coming sell-off could be far worse than in 1994, Euromoney surveys the current state of the rates market in which investors, so many of whom have benefited for so long from a rich pay off by buying long-dated treasuries, will now try to hedge their exposure to rising rates.
The news is almost all bad. Liquidity has evaporated in the cash markets. Dealer appetite to take down large customer positions in longer-term debt for clients looking to shorten duration is severely diminished by dealers’ difficulty in managing outright market and basis risk in turn. New regulations and operational complexity have almost closed the derivatives markets to many investors and corporates.
A few might save themselves through outright shorts, payer swaptions and forward curve steepeners, but if the bond market turns ugly most will suffer big losses.
