Thursday, November 21, 2013

Bond Markets and the Ever Elusive Taper

Bond market watchers have, in recent weeks, become mindful of what is widely perceived to be an possible game changer: If the Federal Reserve, as expected, announces an exit strategy from its $85 billion per month bond-purchasing program, known as QE3, investors can expect a rise in yields and a fall on bond prices, effectively ending the secular bull market in fixed-income securities that has prevailed since the inception of the Fed's zero-interest rate policy in December of 2008.

A concurrent and highly relevant development is notably absent from the recent discussion of the trajectory of the bond market: the imminent (it now seems) appointment of Janet Yellen as the new Federal Reserve chairmanwoman. Yellen's academic career as well as her previous contributions to the direction of monetary policy (she is the current Vice Chair at the Fed) indicate one thing for certain: her moral suasion as formal leader of of the Federal Open Market Committee will favor continued monetary expansion. As far as inflation "hawks" and "doves" are concerned, she is firmly the later. 

Continued expansion in the short-term is just what bond markets ought to expect regardless of changes in leadership. At the inception of QE3 in December of last year, Chairman Bernanke stated that the bond purchases would continue until inflation exceeded 2.5% or unemployment fell to 6.5%. Neither metric is near these parameters. The Federal Reserve, always wary of losing institutional credibility, is even more so in the last five years since its primary policy tool, adjusting the Federal funds rate, has failed to return the economy to full employment. Reneging on an explicit policy pronouncement is unlikely to be on the Fed's agenda.

On a longer time spectrum, and with the assumption that Yellen's tenure will result in a continued expansionary stance for monetary policy, longer-term bond yields are actually as likely to rise as to fall. If unemployment remains high and the economy continues to operate below potential, the "liquidity effect" caused by swapping monetary base for interest-bearing Treasury bonds will hold rates down all along the yield curve. If, on the other hand, a consistently expansionary stance of policy actually succeeds in boosting demand, creating jobs, and moving the economy toward full employment, inflation expectations will rise. At this stage the "Fisher Effect" will dominate, and nominal interest rates will rise as investors demand a premium to protect their real yield from erosion by inflation. In short, bond investors won't feel the heat unless it's generated by the labor market.

No comments:

Post a Comment