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The Fed recently triggered a spike in Treasury bond yields with a gentle hint that it might begin to scale back its purchases later this year. Markets appear to have taken the Fed at its word, in so doing providing clear evidence that quantitative easing (QE) has created a large bond bubble. But a look at real bond yields and the economy reveals, in fact, that the Fed is bluffing. Indeed, a continuation of bond purchases and possibly new unconventional stimulus measures are more likely than a tapering and are bullish for Treasuries, although potentially bearish for the dollar.
Consequences, Intended or Not
Back in 2009, when the Fed and other central banks embarked on variations of quantitative easing (QE) policies, the general justification given was that this was required to prevent deflation, stabilize the financial system and provide a basis for a return to sustainable economic growth.
According to some, QE has succeeded. Consumer price deflation has been avoided. Asset prices have generally risen, in some areas quite dramatically. While banks remain undercapitalized, they are not facing a run as they were in early 2009. Economic growth was generally positive in the major economies until last year, when the euro-area slipped into recession. In the US, growth has remained positive, although it has clearly weakened of late[1], and the unemployment rate has steadily declined.
Therefore, the Fed’s recent hint that it is time to prepare for an eventual scaling back of QE seems reasonable at first glance. And markets have taken the Fed at its word, with Treasury yields rising quite dramatically over the past month, although they do remain low in a historical comparison.
Regular readers of the Amphora Report will not be surprised that I have a somewhat different take on these developments: What the bond market is now telling us is not that the Fed will begin tapering its purchases; rather the opposite, that the Fed is likely eventually to increase them instead.
The key to understanding this is to consider why bond yields were so low in the first place. Back in 2010, when QE was finally being perceived as a medium- rather than merely short-term, emergency policy, I wrote the following, in The New Conundrum of Low Treasury Yields:
Given the large presence of non-discretionary buyers in the [Treasury] market, it is questionable whether or not the observed yield curve at present is close to where a purely discretionary market would place it. There is also the issue to consider whether, given this market structure, investors are discouraged from shorting the market even if they anticipate higher yields in future…
[T]hose investors shorting Treasuries with a longer-term view that yields are headed higher someday as a debt/currency crisis eventually arrives must assume the risk in the meantime that the monetary authority chooses to monetize some portion of the debt, thereby preventing a rise in yields. In this case, those who are short are going to sustain losses in the domestic currency. And unless the domestic currency weakens, those short are going to sustain losses in terms of other currencies as well. It is only in the event that the currency devalues that investors going short will profit. Such perceptions of risk, influenced as they are by credible threats from the monetary authority, most certainly contribute to the conundrum of low yields in the face of rising risks of a debt/currency crisis in future.[2]
Well, you reap what you sow. When the Fed indicated last month they might re-arm the bond market vigilantes by tapering QE, 10y Treasury yields promptly rose by about 0.5 percentage points (50bp). This clear evidence demolishes the theory preferred by Paul Krugman and others that low Treasury yields were indicative of investor complacency with respect to the poor US fiscal position and future risks to the purchasing power of the dollar. Just a hint that the Fed is going to step back has demonstrated the unfortunate reality.
Indeed, a look at real yields (adjusted for inflation expectations) illustrates this point even more clearly. Following a previous, modest rise over the past year, consumer price inflation has been trending lower of late. And US inflation-indexed Treasury bonds (TIPS) show that future inflation expectations have been declining in tandem. So-called inflation break-evens – the observed difference between TIPS and nominal Treasury yields—have sunk to nearly 2%.
The rise in real yields in response to the taper talk has thus been even greater than the rise in nominal yields, at nearly 0.7 percentage points (70bp). This is a large rise in a historical comparison and provides the strongest evidence that the Fed has been aggressively suppressing yields through QE.
Now imagine: Were the Fed to announce something rather bolder, say that they are going to end QE for good tomorrow, the Treasury market would probably crash, setting off a cascade of margin calls and throwing the US financial system into a state of complete chaos comparable or perhaps even worse than late 2008. And all this with short rates still at essentially zero. Imagine the Fed announced that they were going to raise rates! Oh, the horror!
Thus with one timid announcement the Fed has demonstrated not only to what extent they have been manipulating the bond market; they have made it clear that they have no choice but to continue to manipulate it or they are going to crash the US financial system. Now what choice do you think they are going to make?
Backtrack… Backtrack… Reverse!
The Fed has already backtracked somewhat, dropping several hints in the financial press and subsequent speeches last week from NY Fed President Dudley, Governor Stein and others that they have been misunderstood and still fully expect to continue with QE for some time yet. In the event that the US economy continues to slow, they are probably going to backtrack even more. If it slows enough, well then everything is right back on the table, and not only a continuation of QE.
Back in 2002, shortly after his arrival at the Fed, Bernanke gave a speech in which he detailed a series of unconventional steps the Fed could take to prevent deflation.[3] Well, with inflation expectations having declined, growth having decelerated and the taper talk having threatened to accelerate both trends via higher yields, it is likely not only that the Fed will continue with QE, rather than taper purchases, but will draw another arrow out of the unconventional policy quiver in the coming months.
So what is the next step likely to be? According to Bernanke’s remarks, once the Fed has already cut rates to zero, provided extended forward guidance on rates and implemented QE to some degree, the next policy to try is an outright cap on bond yields at a level claimed appropriate to achieving some growth, inflation or unemployment target. In the present instance, a nice round number for a cap on 10y yields would be 2%. If this failed to generate the desired effect on asset markets generally, that is, higher equity prices and other expressions of declining risk premia, then the Fed could lower the level of the cap in increments, perhaps in quarter percentage points.
This may seem a radical policy but it is really just a logical extension of what has been tried to date. It is also not new. Shortly after the US decision to declare war in 1941, the Fed placed a cap on Treasury yields of 2.5%. This cap remained in place for nearly 15 years, until much of the subsequently accumulated war debt was retired via tight fiscal policy in the late 1940s and early 1950s.
How to Play It
While I am hardly a long-term bond bull, the Fed has painted itself into a corner. Not only are they highly likely to continue purchasing bonds at the current rate; they may eventually intervene even more aggressively, possibly by outright capping Treasury yields. Investors sharing this view should consider building tactical longs in US Treasuries. A sub-2% 10y yield target seems entirely reasonable and, if economic data deteriorate further, I would not be at all surprised by a sub-1.5% yield. Ultimately, as the Fed has the theoretical power to cap yields wherever they like, even lower yields should not be ruled out.
One implication of capping Treasury yields, however, is that the Fed will lose control of its balance sheet. A cap requires theoretically unlimited purchases or it is not a cap. Just ask the Swiss National Bank (SNB), which saw its balance sheet explode with foreign exchange reserves following its decision to cap the value of the franc versus the euro back in 2011.
A rapid increase in the size of the Fed’s balance sheet implies a number of things for financial markets. First, it implies a surge in the dollar monetary base, although amid weak growth this may not result in broad money or credit expansion. Second, it implies higher USD asset prices generally, just has been the case with QE to date. Third, holding all other factors equal, it implies a weaker dollar. Whether the dollar indeed weakens or not depends on developments elsewhere. For all I know, other central banks might respond to a Fed rate cap with rate caps of their own; foreign governments might fix their currencies to the dollar to prevent currency strength; they might retaliate with trade restrictions; or some combination of the above. All’s fair in war, and this includes currency war.
No one can predict with certainty what the various reactions around the world are likely to be, either by economic officials or in the financial markets. This is the world we live in. The number and scale of the qualitative risks are vast in comparison to those that can be precisely quantified. Pure uncertainty rules the present and, best as I can judge, the near future.
In this context, the ongoing plunge in the price of gold is looking increasingly curious. I was surprised to see gold break below $1,300 in May and was even more surprised to see it (briefly) break below $1,200 last week. Yes, gold looked expensive versus most commodities last year and a relative price correction was overdue. But we’ve got to the point now, especially given the evidence that the Fed is in its greatest bind yet, where gold should be finding support as the ultimate financial insurance policy.
Gold Down to $1,200, But Holding (So Far)
There is some evidence of strong physical demand and rising premiums for spot delivery in Asia, but quite obviously this has not yet been sufficient to support prices in London or New York. The movement of gold from west to east is palpable, however, and visible in official data. Numerous unofficial, anecdotal reports back this up.[4]
Even though I continue to believe that gold remains in a long-term secular uptrend I haven’t added to my holdings since 2010. Last year I preferred to increase holdings of platinum, agriculture and energy instead. (My most recent purchase was coffee.) Recently, I have been most active in relative value trading, due to an unusually large number of commodity pair price ratios reaching historical extremes. But things have got to the point now where I’m going to add some gold again. The fundamental reasons to own gold remain as if not more compelling than ever, and the price is once again attractive not just in outright but in relative terms.
Platinum Remains Good Value vs. Gold
If Gold Is Good Value How About Coffee?
Amphora Subscription Details Update
Work continues in preparation for a switch-over to a paid subscription service for the Amphora Report, including a new host website. Thanks to all who have expressed interest; I’m pleased with the response so far. I’m also working on getting some useful analytics available online to assist subscribers with financial and commodities market analysis, including that which can be utilized for commodities relative value trading, as featured in these pages from time to time, including just above.
If you are interested in a future subscription to the Amphora Report or in receiving more information about analytical techniques and tools useful in commodities trading and investing, please send me a mail at the address below.
Resources
[1] The most recent revision to Q1 GDP growth estimated it at only 1.8%, and now that fiscal policy is being tightened and bond yields and mortgage rates have risen, it is almost certain that growth will slow further. Another indication of this is that Q1 real final sales—a core measure of GDP—increased by 1.2%. In another indication of slowing growth, US broad money growth has slowed to about 4%.
[2] The New Conundrum of Low Treasury Yields, Amphora Report vol. 1 (July 2010). The link is here.
[3] “Deflation: Making sure ‘IT’ Doesn’t Happen Here,” July 2002. The link to the speech is here.
[4] There have been numerous reports of higher premiums for physical gold in the Middle East, India and East Asia. Also, there are reports of little spare capacity in secure international physical gold transport at present. Regardless, official gold import/export data and ongoing, documented purchases by central banks indicate unusually large physical gold flows have been underway in recent months.
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