U.S. Treasuries have continued to disappoint since our May 20 note that viewed “weakness as a buying opportunity.” Increased speculation about the imminence of the Fed’s tapering its asset purchase program, commonly referred to as QE3, is largely to blame; however, the market’s ultimate reaction to such a move is anything but clear.
First of all, tapering and tightening are not the same thing. Tightening is tantamount to stepping on the brakes, while tapering is akin to easing up on the gas pedal. Whether this analogy holds true depends on which “effect” the market is more sensitive to.
The “stock effect” view of asset purchases would argue that tapering is still an accommodative policy, as the Fed’s balance sheet would continue to grow, albeit at a slower pace. Conversely, the “flow effect” view would see decreased purchases as a tightening policy, as the monthly pace of purchases would have declined, reducing downward pressure on interest rates.
Either way, it is important not to view potential tapering in isolation. One of the secondary benefits of the QE programs was easy funding of the U.S. government’s huge deficits, which themselves blunted the efficacy of the bond-buying programs, and which (post-sequestration) have been reduced to almost half of what they were relative to GDP only two years ago.
Therefore, even reduced asset purchases could be able to produce the desired effect of lower interest rates, and actual tightening, by means of either shrinking the Fed’s balance sheet or raising interest rates, still seems to be a distant event.
Secondly, the commonly accepted belief is that when the Fed is buying bonds, yields go down, and when they stop buying bonds, yields go up. But even a cursory examination of Treasury yields surrounding the first two quantitative easing programs reveals that the opposite may in fact be true. Chart 2 illustrates that in both cases Treasuries saw significant drops in yield in the months following the end of previous QE programs. This may not, however, provide a clear roadmap with which to navigate the termination of the current program.
The previous two QE programs had defined ending dates, unlike QE3, for which the end is discretionary and intended to be based on improving economic fundamentals, and therefore can be viewed as more of a signal to the market that the Fed is shifting to a slightly less dovish stance. Indeed, any lessons we may take from history could be misleading, as balance sheet expansion of this magnitude is unprecedented.
The selloff in U.S. Treasuries reflects an optimistic market that has grown complacent with regards to risk. Sensitivity to economic results should be high over the summer months, as Fed tapering will likely be announced only after an FOMC meeting and press conference, providing Fed Governor Ben Bernanke the opportunity to thoroughly explain the shift in policy. That could happen in September or December of this year.
In the meantime, we maintain our long bias, again favoring longer-dated maturities.