Happy New Year

December 31st, 2013 9:09 am | by John Jansen |

Prices of Treasury coupon securities have registered small losses in overnight trading. One dealer reported a level of activity inconsistent with the holiday season as clients were surprisingly active as the year is drawing to a close. Central banks bought bills and real money bought 2s and 3s. Prop traders (now almost the financial market equivalent of one of George Carlin’s famous seven dirty words which which the Supreme Court eventually opined upon) bought 5 year notes and central banks in their infinite wisdom sold 10 year notes. The yield curve is flatter than it was twenty four hours ago with 5s 30s at 219 versus 221 yesterday.

This was certainly a fascinating year for financial markets as the notion that the Federal Reserve could alter policy to a less accommodative stance turned the bond market apoplectic in the May through September period when the yield on the investment grade 10 year note nearly doubled (1.62 May 02 and 3.00 September 06). Then the FOMC surprised participants with a no taper in September and then finally with a taper in December.

I am not a fan of making long term predictions because it is hard enough to know where the 10 year note will be an hour from now. Nevertheless, I will venture into the predictive quicksand.

 

I think that the recent FOMC move to taper is significant because it is the first time since August 2007 that the FOMC is less accommodating. The salient point is the directionality of the policy shift and the simple fact is that the marginal buyer is heading for the hills. The policy makers have their notions about the stock of bonds in their portfolio and the consequences of holding those balances. I think that the spring and summer move in 2013 proved that what matters is the flow of purchases by the central bank and as they adjust that flow (lower) then ,ceteris paribus, it will have consequences. So the central question for 2014 is how quickly do they reduce their purchases and what are the supply and demand factors which will follow.

I think that the policy makers believe that they can mimic King Canute via forward guidance and stop the rising tide of interest rates. Canute could not stop the tides and I do not think that a gaggle of apparatchiks with PHDs and pompous power point presentations ande murky models can hold markets in check. I think that the experience of last spring and summer is a testament to that. As we go forward in 2014 I think that we will see unwinding of positions established over the last six years. That will be a long and arduous process and risk is unwound. I think the area of greatest vulnerability is spread product as that is what investors own and not lowly Treasuries.

To be fair the other dynamic is liability driven investors and their appetite for assets as rates rise. I have chronicled here several stories recently of pension funds buying corporate bonds at or near 5 percent (in the 20 year and 30 year sectors) and there was receiving in swaps when the forward curve provided opportunities to receive near 5 percent. If those portfolio managers perceive value around those levels then the rate rise should be quite modest. If they choose to sit on their hands it might get quite severe.

The other factor is a behavioral factor. The FOMC has not engaged in a serial tightening in years (taper is not tightening I know but it is a policy change which will make investors think that it is or that one is coming sooner rather than later) and that collective inexperience I think will make matters worse.

Anyway, I run on on New Years Eve. Thanks for reading Acrossthecurve.com and I look forward to posting my mind droppings here in 2014.

 

 

 

 

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