Comments from Fed Chairman Ben Bernanke late last week sparked one of the worst single-day bond market sell-offs since last May. The vast majority of his speech centered on the Fed’s balance sheet but the market focused on remarks about possible exit strategies and removal of monetary stimulus. Bernanke hinted at tightening monetary policy by stating the Fed would “tighten monetary policy to prevent the emergence of an inflation problem” when “economic recovery takes hold”. The market took it as the first step towards eventual interest rate increases and Treasury yields jumped by 0.08% to 0.14% on the day.
Upon closer inspection, market reaction seemed exaggerated given the content of Bernanke’s speech. First and foremost, Bernanke’s statement to tighten monetary policy when economic recovery takes hold to prevent an inflation problem down the road was almost identical to language used in his July 21 Op-Ed piece in the Wall Street Journal discussing the Fed’s exit strategy. This was not new information but the market chose to react negatively this time. Bernanke also reiterated the “extended period” message regarding “accommodative policies” but that was ignored. Bernanke’s speech did include some adjustments that could be considered new. In discussing the Fed’s exit strategy, Bernanke described exit strategies with slightly more detail than the broad steps outlined in his July Op-Ed piece. Bernanke also made a second mention of a “tightening stance of monetary policy” when the economy improved “sufficiently” in regards to when the Fed’s balance may return to a more normal state. This last comment was a loose repeat of his first reference to tighten policy and targeted to those worried about the Fed’s balance sheet.
How Did The Treasury React?
Treasury market reaction was exacerbated by a weak 30-year bond auction and illiquid trading conditions. Treasuries had closed lower Thursday following a weak 30-year bond auction which left bond dealers with more inventory than anticipated. Limited liquidity (i.e., the ability to easily buy and sell bonds) ahead of a long Columbus Day holiday weekend for the bond market added to the downside. Treasury yields at the low end of a range also prompted investors to sell.
Financial markets dislike uncertainty and the bond market also reacted to growing ambiguity by the Fed. Since the September 23 FOMC meeting, Fed speakers have sent mixed messages to the market. Regional Fed presidents Fisher and Lacker along with Fed board member Warsh warned of rate hikes while Vice Chairman Kohn and Atlanta Fed president Lockhart voiced a need to maintain accommodation. The mixed messages contrast to the “on hold for longer” message from the last FOMC statement. Messaging will have to be monitored going forward but this likely part of the Fed’s desire to keep investors inflation expectations contained.
Gauging the timing of the Fed’s actions is important for bond investors as the Fed indirectly is a key driver of bond market performance. Short-term bond yields are highly correlated with the Target Fed Funds Rate. Fed rate changes also impact intermediate to longer-term bonds but longer maturities are influenced more by inflation. Generally, Fed rate hikes have resulted in lower bond market returns.
We believe inflation will remain contained such that the Fed can wait until the latter half of 2010 before hiking interest rates. Historically the Fed has waited for a sustained decline in the unemployment rate before increasing rates. The Fed will likely wind down non-traditional “quantitative easing” measures fi rst before increasing interest rates. Special emergency liquidity programs instituted in the fall of 2008 are being gradually closed or reduced.
More Cash
Recent Fed comments may have been spurred by concern over large amounts of cash returning to banks. The Treasury bill (T-bill) market is in the process of shrinking by $185 billion as the Treasury winds down its Supplementary Financing Program (SFP) T-bill program, another program instituted in the fourth quarter of last year to help bond market liquidity. The Fed’s next step, therefore, might be large scale reverse repurchase agreements. In a reverse repurchase agreement, the Fed would sell Treasuries to banks (bond dealers) in return for cash thereby limiting a potential source of excess buying power that might fuel inflation. This is one of several policy options the Fed can, and likely will, pursue before increasing the Federal Funds target rate.
On balance, we do not view Bernanke’s comments as overly bearish for the bond market or the start of sustained rise in interest rates. Rather we view it as the first of many baby steps by the Fed that will eventually culminate in a Fed Funds rate hike. Expectations of a Fed rate hike, as measured by Fed Fund futures, increased but finished the week where pricing had been for most of September: fully pricing in a rate increase by the April 2010 FOMC meeting up from the June meeting.
Bernanke’s comments likely confirm the end of a 4-month Treasury rally but do not suggest the end of a broader Treasury trading range, defined as a 3.3% to 4.0% yield range on the 10-year Treasury. We believe our portfolios are positioned correctly with an emphasis on “spread” product (Corporate Bonds, High-Yield Bonds, and Emerging Market Debt) which will help absorb the impact of higher interest rates while generating higher interest income. We believe it is too early to shift to short-term bonds and intermediate bonds better capture the yield advantage of non-government bonds.
IMPORTANT DISCLOSURES
- This report was prepared by LPL Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
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- Government bonds and Treasury Bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
- The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
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- GNMA’s are guaranteed by the U.S. government as to the timely principal and interest, however this guarantee does not apply to the yield, nor does it protect against loss of principal if the bonds are sold prior to the payment of all underlying mortgages.
- High yield/junk bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors.
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