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Dave Rosenberg is enjoying his moment.
On Thursday the Gluskin Sheff man took to his morning notes to answer one of the big questions regarding the Fed’s last — and future — bout of quantitative easing. Back in early 2009, the Fed set out to stimulate the economy by flattening the yield curve with its QEasing. It worked initially, but then yields began creeping back up. What then, will be different this time?
Rosenberg has some ideas:
As for bonds, it is 100% true that when the Fed first said it would buy Treasuries back in December 2008 we had a huge announcement effect that drove yields down, but then they backed up rather sharply thereafter. That was because the Fed started buying the bonds right near the lows in the economy and the stock market and that brief era of "?green shoots' took over. Now the Fed is doing the buying ($18 billion worth from August 17 to September 13) at a time when the bear market rally and the peak in growth are well behind us. Time to put the bull flatteners on if you haven't done so already.
So down, down damn yield:
The pledge to ramp up the Treasury buying program at rough estimates of $200 billion annually could just be the thin edge of the wedge because all the Fed did was to adjust lower its near-term economic view "” it still is calling for 3.5-4.2% real GDP growth for 2011, as of June. Remember when the Fed was calling for 2008 real growth of 1.8-2.5% back in October 2007 even though it was becoming so apparent at the time that the credit system was imploding (though the equity market was making a last gasp to a new high at that time) and what did we end up with? Try -2.8% for 2008. As a result, the Fed got aggressive and the funds rate went from 4.5% that month to near-zero just over a year later.
But the Fed cannot cut the funds rate any more. So it comes down to the experimental tool kit. As a result, we have to continue to read and re-read what Dr. Bernanke said he would do in these circumstances "” pushing on a string with deflation risks staring us in the face "” in that famous speech he gave on November 21, 2002 when he was still a Fed Governor (Deflation: Making Sure "It" Doesn’t Happen Here). He laid out the guidepost for investors on how to navigate through this, and the bull flattener in bonds is the obvious strategy. One of his recommendations, as you will see in the excerpts below, involves an explicit ceiling on long bond yields at 2½%!
The relevant bit of the 2002 Bernanke paper — also enjoying something of a moment — talks about the Fed maintaining a ceiling of 2.5 per cent on long-term Treasury bonds for nearly a decade before 1951. (As a side note, it managed to do that without actually buying big chunks of the longer-dated stock).
Back to Rosenberg:
When Bernanke delivered this sermon, the inflation rate was 2.2% (1.1% today), the core inflation rate was 2.0% (+0.9% today) and the unemployment rate was 5.8% (9.5% today). With that in mind, the case for more bond buying is actually pretty strong. And, if we do end up going to 2.5% on the long bond with the help of Helicopter Ben, that would imply a total return of well over 30%. It has taken the stock market nearly 13 years to achieve that result! . . .
Buying more Treasuries at some point, perhaps not that far off in the distance, is still in the policy arsenal and as such, today's near-4% yield in the long bond is going to look a whole lot like the 5% yield back in the summer of 2007, the 6% yield in the spring of 2000 and the 7% yield back in the fall of 1996 "” a bargain.
You can see this across the yield curve as the 2-year note converges on Fed funds; the 5-year note on the 2-year note; the 10-year note on the 5-year note; and the long bond on the 10-year. Every segment of the curve will be flatter when this thing is over, and when it is over, yields across the curve will be at stupid-low levels. What sort of levels? Well, consider that in the past decade, the average spread between the 10-year note yield and Fed funds is 160 basis points; between the long bond and Fed funds is 210 basis points; and between the long bond and 10-year note, the spread has averaged 50bps (it is 125bps today!).
No matter how many bonds the Fed buys, it came out emphatically this week and said that economic conditions are "likely to warrant exceptionally low levels of the federal funds rate for an extended period." And, there is no more powerful a variable in influencing the direction in bond yields than Fed policy "” it commands an 88% correlation versus 75% for core inflation and 40% for budgetary deficits. When you look at what the yield curve will look like at the yield lows, a move to a 1.5-2.0% range on the 10-year note and 2.0-2.5% on the long bond is completely achievable, as crazy as this may sound.
Bernanke bought bonds in 2009 and yields still backed up because of a V-shaped inventory- and policy-induced recovery in the economy and an 80% bounce in the equity market off the lows. Even with that, the yield on the 10-year could never manage to break above 4%. But now the peak in the fiscal stimulus is behind us, the peak in the inventory cycle is behind us, the peak in growth is behind us, and a very uncertain economic landscape confronts us and the Fed is the only game in town but with all its bullets shot in terms of the funds rate. So, Bernanke et al are now going to be increasingly targeting longer-term interest rates as a means to revive growth, mitigate double-dip risks and avoid a potentially destabilizing deflationary experience "“ a "thin tail" event, perhaps, but one that carries with it a higher economic cost than the Fed Chairman is willing to bear.
If you think that it is completely nutty to think that yields cannot go to microscopic levels, even with large-scale government debts, then consider that in the past, at the peak of bull markets in bonds (the ultimate lows in yields), the curve gets so flat that the average spread between the long bond and Fed funds is 100 bps (and 25bps between long bonds and 10-year notes). It would seem that just as the BB sliver in the corporate bond universe was the laggard with the greatest return potential, within the Treasury curve (Canada curve too since the long end trades more off the U.S. rate structure than what the Bank of Canada does … or doesn't do) it would seem that the long end (again, the laggard) carries with it the most compelling total return opportunity (inflation expectations are still far too high).
That would be quite a step-change, considering 30-year bonds seem to have been left out of the recent UST rally. The difference between the 10- and 30-year reached a record high on Wednesday, for instance, the day after the Fed announced its new Treasury-buying plans.
That said, the spread was already narrowing on Thursday — after a decent new 30-year auction and some market talk that the Fed will be buying long bonds too, as part of its QE II.
So, future flattening?
Time will of course tell.
Related links: Deflationary fears send Treasuries off charts - FT That "?Monster QE, markets-on-a-cliff-edge,' RBS note – FT Alphaville Convexed - FT Alphaville, 2008 Who’s capturing yield? – FT Alphaville
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