Raymond James: The Bond Market’s Reaction Since Last Week’s QE3 Announcement


Raymond James Bond Market CommentaryAll the Eggs in One Basket
By Benjamin Streed
September 17, 2012

As noted in last week’s commentary, prior to Thursday’s big announcement from the Federal Open Market Committee (FOMC) it appeared as though the markets were expecting something rather extraordinary as indicated by the spread between 2-year and 5-year Treasuries. The difference in yields sat at a mere 39bp, the lowest level on record leading up to the announcement but has since pulled back toward 46bp as overall yields rose post-announcement. For the week yields are up significantly with the longer-end of the yield curve leading the way: 5-year notes yield 0.713% (+6.9bp) while 10-year and 30-year rates were 1.866% and 3.088%, up 26.4bp and 19.8bp respectively. These current levels mark a nearly four-month high in interest rates but could face resistance given how quickly yields have risen over such a brief period of time.

The yield rally comes on the heels of an unprecedented move by Federal Reserve Chairman Ben Bernanke who announced a third round of asset purchases, dubbed Quantitative Easing 3 (QE3), which will further aim to bolster the struggling U.S. economy and unemployment situation. The Fed previously purchased nearly $2.3 trillion in securities in the first two rounds of QE which date back to 2008 in the aftermath of the financial crisis. What is different this time is that there is neither a definitive limit on the amount of securities the Fed will purchases nor any specified date for the end of the program. Included in QE3 is a promise to purchase $40 billion per month of mortgage debt and to keep interest rates at “accommodative” levels, aka near-zero, until “at least mid-2015”. This relatively unlimited monetary stimulus will continue until the FOMC sees “sustained improvement” in the labor market and, as such, policymakers chose to move away from the containment of inflation in their dual mandate to solely focus on the labor market for the foreseeable future. Moving forward it seems likely that the market will scrutinize any economic indicators tied to inflation as the Fed has now put “all its eggs in one basket” so to speak. The breakeven rate for 5-year Treasury Inflation Protected Securities (TIPS) over similar maturity Treasuries, an often quoted measure of inflation expectations over a 5-year time period, stood at 1.92% before Bernanke’s speech in Jackson Hole, Wyoming on August 30th and now sits considerably higher at 2.37%, marking its highest level since April of 2011. The ten-year breakeven rate for TIPS spiked over 9bp to 2.73% marking its highest level since May 2006.

As a side note, the FOMC’s decision was not unanimous as Richmond Federal Reserve President Jeffrey Lacker, the lone dissenter in Thursday’s announcement, stated that the allocation of this amount of monetary stimulus should be left to Congress or the U.S. Treasury. He stated, “I strongly opposed purchasing additional agency mortgage-backed securities”, and that, “channeling the flow of credit to particular economic sectors is an inappropriate role for the Federal Reserve”. Not only did he disagree with the “how” of the new round of QE, he also strongly disagreed with the “why”: In opposing the language of the decision he noted that, “an implied commitment to provide stimulus beyond the point at which the recovery strengthens and growth increases would be inconsistent with a balanced approach to the FOMC’s price stability and maximum employment mandates”. This comes as little surprise as Lacker has dissented at every single FOMC decision in 2012.

Corporate credit continues to thrive in this new environment as issuers borrow record-breaking amounts of money here in the U.S. According to Bloomberg data, year-to-date domestic corporate issuance sits at $1.034 trillion which tops the previous record of roughly $904 billion set back in 2009 just after the height of the financial crisis. Credit spreads, as measured by the 5-year Markit CDX Index, continue to tighten and now sit at only 84.4bp, which is well off of its 2012 high of 127bp set back in early June. The most pronounced change in credit spreads continues to be in the banking/finance sector as spreads have continued their sharp decline since mid-summer. According to Citi YieldBook data the spreads on investment-grade finance bonds sits at 219bp currently, which is down from the 2012 high of nearly 325bp and now rests at levels not seen in over a year.



The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.

To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section ofinvestinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.



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