To Infinity and Beyond …
By Zach Berg, CFA
January 30th, 2012
… or at least to the end of 2014. The Federal Reserve provided further policy easing this past week, this time through its communication strategy by increasing the time it conditionally expects to keep rates low, while also potentially signaling that QE3 may be warranted in the future. In its FOMC statement release, the Fed altered the language concerning the target range for the Fed funds rate, pushing out its expectations for a rate hike 18 months by replacing a mid-2013 commitment with the following, “are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.” Additionally, the Fed openly adopted an explicit inflation target of 2% on the headline Personal Consumption Expenditure (PCE) inflation index within the context of its dual mandate to maintain price stability and promote maximum employment. The markets reacted swiftly with Treasury prices moving higher (yields lower) across the curve, while in other fixed income markets investors faced with lower rates for longer looked to pick up incremental yields in other fixed income product types. Within the broad Treasury move, the belly of the curve experienced the greatest relative compression with the 5yr note hitting a record low yield at the time of 0.76%. That level would be later taken out throughout the remainder of the week, as the belly of the curve re-priced the Fed remaining on hold for even longer.
Interestingly, although the FOMC statement contained the language implying an initial rate hike may not occur until late 2014, the fed fund futures market does not currently reflect this timing cycle. As the chart below displays, the market clearly pushed out expectations, but only to mid-2014 as opposed to the end 2014. It appears that traders are formulating their rate hike expectations around the distribution of Fed participant’s forecasts versus the actual statement language.
This discrepancy may create a situation in which 5yr yields have the potential to set even lower record yields over the next few weeks if the fed fund futures market begins to move closer to the statement language. While this type of move would flatten the front-end of the curve for a majority of fixed income products, it would also have the potential to create a steepening bias in the 5-10yr portion of the yield curve. A flat front-end and steeper intermediate Treasury curve equates to greater roll returns, as well as, increasing the need for alternative sources of carry for institutional investors which may increase the attractiveness of higher yielding fixed income assets such as corporate bonds and mortgages.
On the long-end, 30yr yields initially reacted Wednesday by falling approximately 18bp, but later retreated from those levels during the day, partially on the prospects of further quantitative easing, which is associated with higher inflation expectations. Although the Fed stated their inflation objective of 2%, Chairman Bernanke relaxed this target as a hard line in the sand during his press conference, implying a Fed’s willingness to temporarily tolerate a higher inflation level if it were viewed as a means to stimulate a stagnant economy. This admission to allow a short-term observance of higher inflation at the cost of avoiding deflation and sparking economic activity, coupled with the simple fact that the Fed appears to be on hold for a more extended period has historically led to higher inflation expectations. Additionally, the prospects of further quantitative easing, which Chairman Bernanke stated in his press conference was under consideration, may also add to these pressures. However, unlike the announcement of QE2 which pressured long-dated rates as the inflation expectations component increased, the announcement of an explicit long-term inflation target of a 2% may have the ability to stem a rampant increase in inflation expectations helping to reduce the stress on long-dated yields. The confluence of these dynamics will be worth noting during upcoming weeks as the Treasury yield curve, especially the 2-5yr, 5-10yr and 10-30yr curves reposition themselves.
With the first release of the Fed’s projected rate path out of the way, the Greek debt drama may move back to the forefront this week. European Economic and Monetary Affairs Commissioner Olli Rehn was quoted Friday by Reuters saying, “We are very close to a deal, if not today then over the weekend and preferably in January.” The need to move quickly on a deal is growing with each passing day as the March 20th payment of €14.4 billion gets closer and closer. The possible outcomes to the private sector involvement (PSI) debt negotiations that are currently taking place are complicated, but here are four broad simplified issues to be mindful of:
- Will any accord reached be able to invoke at least a 90% voluntary private sector debt holder response? A failure to reach this level of participation will create a shortfall that will need to be filled by either the International Monetary Fund (IMF) or the by EU, in the form of the ECB. It would be unlikely that the IMF would step into this role based on the need for a parliamentary vote; however, the ECB would require no such vote making it a more likely candidate.
- If the Greek PSI deal falls apart and no deal can be reached, a negotiation between Greece and the “Troika” (the European Commission (EC), IMF, and the ECB) will need to occur to secure a bailout needed to avoid a missed payment and a default. These discussions would likely center on greater austerity measures in the form of fiscal and structural reforms.
- The end game of no agreement between the “Troika” and Greece may very well be a Greek exit from the EU. A further implementation of harsh austerity measures may be too great a burden for the Greeks to bear considering that according to a report on Friday, Greece is already developing a plan to leave the EU. (Greece plans orderly exit of the Eurozone – International Trade Examiner)
- In any of the latter three scenarios above, a key question will be whether or not a credit default swap event is triggered. Certainly in the last and worst possible outcome a CDS event would surely be triggered, but the answer to the middle two would be based on the structuring and losses debt holders may have to take.
Adding to the complication of the Greek negotiations are news headlines stating that Germany wishes to have the EU run the Greek budget. Not surprisingly Greece has rejected these calls, potentially setting the stage for breaking news barrage this upcoming week of back forth between Greece, Germany, and the rest of the “Troika.” Thus the week ahead commences with a market anxious for a Greek solution and once again susceptible to volatile trading swings as Treasury yields begin the week lower across the curve.
A Little Food for Thought …
This past Thursday, the Japanese Finance Minister made the announcement that it is projected that at the end of their fiscal year in March 2013, the amount of total Japanese debt will surpass the one quadrillion yen market. Yes, one quadrillion yen or roughly $14 trillion U.S. dollars. In a Bloomberg article entitled “The Long Malaise: Similarities Between Japan and the U.S.,” author Joseph Brusuelas compares the Japanese lost decade to the current US economic backdrop. While he acknowledges the differences between the economies, especially the large variation in the consumer behavior of each country, the similarities are strikingly similar in some aspects. He states, “These similarities primarily relate to the unique problems following the piercing of a debt-financed asset bubble that left many households, banks and firms with liabilities that exceeded assets following the bursting of a residential asset bubble.” The U.S. just recently passed the 100% debt-to-GDP ratio, which as Brusuelas points out took just four years for the U.S. to accomplish from the onset of the recession, while it took Japan six years to do the same. For investors asking themselves how long can yields remain depressed, there is a non-trivial similarity between the paths of US 10yr Treasury yields are their comparable Japanese 10yr yields through the first four years following the recession. In the case of Japan, yields continued to fall before finally coalescing in a tight trading range of 0.50% to 1.00% where they remain today.
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