The US Federal Reserve’s Federal Open Market Committee (FOMC) 18 June announcement, which marked the midpoint of the US central bank’s quantitative easing (QE) tapering plan, left the Treasuries and agency mortgage-backed securities (AMBS) markets non-plused.
“We were not expecting a repeat of the second and third quarter of 2013,” commented Thomas Urano, a principal and managing director at asset manager Sage Advisory.
When the FOMC first floated the idea of tapering its monthly purchase of US$85 billion of Treasury and AMBS instruments in June 2013, it caused a temporary spike in the yields of 10-year treasury notes, rising to 2.75% from 1.65%, and leading to a sell-off as investors sought refuge in the US dollar.
Over the past 12 months, the market has been able to digest the FOMC’s tapering program, which it began in February with a monthly US$5 billion reduction in its purchases of both instruments and will end in October for Treasuries and in November for ABMS.
As long as the Federal Reserve repeats its QE purchases and follows its predictive path, we should see a post-crisis 2.5% to 2.75% growth in the US GDP after a weak first quarter and a rebound in second quarter, according to Urano.
“I think the market is comfortable with what Federal Reserve Chairman Janet Yellen is doing,” he added. “That’s why the yield on the ten-year Treasury notes dropped 40 basis points (bps) this year.”
Urano does not expect to see the Treasury or AMBS markets change that much for the remainder of the year.
Events in the Ukraine and Iraq might lead to a momentary flare up in volatility, he explained. “But stepping away from those issues, the dominant picture in the marketplace is whether central banks change their policies.”
Currently, the Federal Reserve is drawing down its economic stimulus by tapering its purchases whilst the European Central Bank is increasing its stimulus with negative interest rates for deposits.
“The net-net is that they wind up off-setting each other,” said Urano. “In the end, it winds up being the same-same for the rates market - low interest rates and a flatter yield curve.”
The only wild card Urano sees is if inflationary pressures accelerate faster and leave the Federal Reserve’s comfort zone.
“I think that would make the Fed a little more aggressive in its rate-hike cycle,” he added. “It’s hard to see inflationary pressures really accelerating to the point where the Federal Reserve becomes really uncomfortable with it.”
The recent Consumer Price Index (CPI), which measures the monthly price change in a basket of good and services for an urban consumer, published by the US Bureau of Labor Statistics, is higher than it has been over the past year.
"People are looking at the data and thinking that inflation is picking up, but it is not out of the Federal Reserve’s comfort zone,” stated Urano. “This tell us is that the Federal Reserve is willing to err and let inflation run a bit rather than tighten interest rate policy too early.”
Overall, Urano has not see a major change in the Treasuries or AMBS liquidity in terms of liquidity over the past six months.
As the Federal Reserve continues to reduce its regular monthly purchase of Treasuries, the US Department of Treasury is reducing the amount of debt it issues due to the shrinking Federal debt.
Additional demand for US Treasuries is also coming from marginal investors, who are leaving the European sovereign debt market due to the ECB’s negative interest rates policies.
By migrating to US Treasuries, these investors could pick up a potential 100 bps-return at the margin, according to Urano.
The current supply of ABMS instruments also is much lower that the market participants thought earlier this year, even with the Federal Reserve’s draw down, he added. “It still creates a positive against a supply versus demand in this space as well.”
In the meantime, Urano expects to see flatter yield curves as the Federal Reserve raises short-term interest rates. “Over the past few months we have noticed that the Federal Reserve has lowered the equilibrium from just above 4% to just below it, which is lower than it has been historically.
As a result, he expects that the yields on the 10-year and 30-year US Treasury notes will be rate bound from 2.5% to 3% and 3% to 4% respectively as long as the Federal Reserve’s planned interest-path holds.