The Initial Impact of QE2: Catalyst for A Bond Bloodbath
The law of unintended consequences is alive and well in the U.S. Treasury markets
We have learned over the years that financial markets have a relatively consistent tendency to make even the most carefully constructed plans look positively foolish in hindsight. Traders, central bankers, politicians, and economists with Ph.D.’s from all the right schools repeatedly underestimate the ability of a given market to price future events rapidly, completely and ruthlessly, as well as to make a mockery of any pronouncements and grandstanding to the contrary. We have also learned that this tendency manifests itself in every facet of finance, whether the subject is an individual stock, a currency, or an entire market.
We wrote in our December issue that a primary concern with the Fed’s QE2 program, aside from its inability to stoke a bona-fide increase in aggregate consumer demand, was that of unintended consequences. If we recall correctly, a primary goal of the program was to concentrate Fed purchases of Treasury debt in intermediate maturity ranges, thus depressing yields along the longer end of the curve. As the nearby graphic shows, precisely the opposite has occurred—the entire U.S. Treasury yield curve has shifted northwards, and nowhere more sharply than within those very intermediate maturity ranges. Indeed, the yield on 10-year U.S. Treasury bonds has been rising literally since the day QE2 was announced, and spiked the most in nearly two years upon news that the Bush-era tax cuts were going to be extended (when one is already printing money hand over fist, what’s another trillion here or there?). And the yield upswing is not being limited to only U.S. paper—European and Japanese yields have been rising as well, and by roughly the same amount. Indeed, increases in European sovereign debt yields have eclipsed that of ostensibly riskier corporate debt, and it is now cheaper (as measured by credit default swaps) to hedge against a corporate bond default in Europe than against that of a sovereign nation. Talk about a sign of the times.
The interesting aspect of this development is that it has come as such a surprise to market pundits. Bond markets around the world have been in a sure-fire bull market for, depending on your definition, anywhere from two to thirty years, and nowhere more so than in U.S. Treasuries. Investors poured a whopping $609 billion into bond mutual funds between March 2009 and October 2010 as the severity of the financial crisis—and the steps being taken to fix it—only exacerbated their safe-haven appeal. Now, with developed economies seemingly on the mend, emerging ones growing quickly, and Western central banks either defending a fiscally crippled currency (ECB) or printing money (the U.S., UK, Japan), it is not hard to understand why investors have blown the whistle on the bond game. Indeed, November saw the first monthly outflow of capital from bond ETFs since October of 2008, which itself was the first since September of 2006. Figures for December weren’t available by the time this issue was going to press, but considering the additional bloodbath that occurred in bonds on news of the tax cut extension, it would be extraordinary if money flows reversed. On the contrary, if equity markets are any guide, they probably accelerated.
It is unlikely that Ben Bernanke intended for QE2 to unleash the biggest re-allocation of global capital in recent memory. Nonetheless, that is precisely what has occurred. While small in absolute terms, it (and the tax deal) perfectly illustrates the law of unintended consequences. Since perception and interpretation can count a lot more than absolute numbers when dealing with markets, seemingly well-intentioned steps can result in a reaction wholly opposite of the one originally desired. Now, instead of dealing with a benign, low-rate environment designed to spur the creation of consumer credit and increase consumption, Bernanke is confronted with a rising rate environment to go along with the price increases consumers are already seeing in virtually everything they buy. It’s the very thing he wanted to avoid.
It has been our contention since the first issue of Cash Cow that one of the three upwardly trending asset classes—stocks, bonds and commodities—would ultimately reverse. With the U.S. Fed printing money with abandon as it plays a dangerous reflation game, bonds were the obvious—and theoretically sound—choice, although we’ve been around long enough to know that markets can continue going in one direction long after theory says they should have stopped. With the horse now let out of the barn, we expect liquidity will continue fleeing global fixed-income markets and heading for equities and the commodities markets. All things being equal, this environment should be highly favorable to Cash Cow’s ETF portfolios.