“Quantitative easing is NOT going away. Every major country is running a deficit. If they are all net borrowers then who is the lender? The central banks. For this reason – QE is not going away for a long time.” –Jeffrey Gundlach, Founder & CIO of Doubleline
May and June has not been kind to fixed income investors. Since the beginning of May, the 10 year US Treasury yield has moved up from a recent low point of 1.61% to around 2.18% today. There has been much speculation as to what has caused this move, but the general consensus is that the market is anticipating a change in the Federal Reserve’s latest QE program. Several members of the Federal Open Market Committee (FOMC) have gone on record stating that the Fed should start scaling back (e.g. tapering) the pace of its bond buying program. Chairman Ben Bernanke, on the other hand, continues to remain very dovish, but he also stated that the Fed could taper bond purchases in the next few meetings if the economic data supported it.
The thinking goes that if the Fed were to buy fewer bonds then rates would go up since the Fed is artificially keeping rates low through their bond purchases. The widespread belief that interest rates are on a one way trip straight up has affected all asset that were being held as “bond proxies” due to their attractive yields. Investments in real estate investment trusts (REITs), utilities, high yield bonds, and other defensive assets have been absolutely hammered the past month. Money has been flowing out of long duration and high yield bond funds in favor of short duration and floating rate bond funds as a way to protect against rising rates.
Oddly enough, the end of QE1 and QE2 had quite the opposite effect on bond yields as investors feared that a QE-less economy would sputter out and roll over into a recession. This created a “risk off” trade where investors flocked out of riskier assets in favor of safer assets like defensive stocks and bonds. But this time around the game seems to have changed as investors are now more confident that the economy is healthy enough to grow on its own without a QE safety blanket. The phrases “risk on” and “risk off” have been replaced with “Fed tapering” and “bond bubble” in the financial media. Some analysts believe the dramatic move up in rates is overdone. A recent research report put out by Raymond James made a statement indicating the rapid movement in bond yields has gotten ahead of itself.
There was no significant increase in long-term interest rates when QE1 and QE2 ended. Similarly, there is unlikely to be much of an increase when QE3 ends. However, there is uncertainty about when QE3 will end. Anything that suggests an earlier end to the program, and therefore a lower amount of total purchases, would have some implications – but not a lot – for long-term interest rates.
Predications about a bond bubble and subsequent bursting of said bubble are nothing new. These types of headlines have been in and out of the financial media since the Federal Reserve first started taking their “extraordinary measures” back in 2008 when they cut short-term interest rates to 0%. In order to believe that interest rates have turned the corner and are truly on the rise, one has to buy off on the fact that the “thief in the night” is knocking on the economy’s door. The thief we speak of is none other than inflation. Without the risk of inflation, the Fed has no reason to relax its very dovish monetary policy of zero percent interest rates coupled with endless QE.
Under normal circumstances, central banks raise interest rates because their economy is overheating and inflation is on the rise. On the flip side, they lower interest rates and incentivize lending when the economy is contracting or deflating. The reason the Japanese interest rates have fallen persistently over the past three decades in the face of multiple QE programs and an enormous sovereign debt burden is simply because their economy has been deleveraging and deflating over this time period. Deflation incentivizes people to hoard their money since their money increases in value over time without the need to take any risk through investment. The opposite is true in an inflationary economy where a currency steadily loses its purchasing power, which thereby incentivizes people to spend or invest in order to stay ahead of the game. Since 2008, the US has increased the money supply (commonly referred to as printing money) in record amounts but, much like Japan, this has not translated into inflation because the money isn’t working its way through the economy. The measure of how fast (or slow) money moves through the economy is known as the velocity of money which is at multi-decade lows right now.
The velocity of money is low because banks are still licking their wounds from the bursting of the credit bubble back in 2008. As everyone knows or has at least heard, it is very difficult to get a loan these days because banks aren’t lending as freely as they have in the past, which isn’t necessarily a bad thing. This lack of credit growth is what is weighing down the velocity of money.
The way it works right now is the Federal Reserve increases the money supply by purchasing bonds from banks with newly created US Dollars, and the banks are choosing to sit on those dollars to help true up their balance sheet rather than use them as reserves for new loans. When the focus of the banking sector turns to solvency over profitability, the banks are said to be going through a “balance sheet recession” according to economist Richard Koo. A healthy bank would normally take those new dollars and use them as reserves for new loans. The way our banking system works is that a bank is required to keep a fraction of their loans on reserve. So every dollar a bank receives can act as a reserve to back 5, 10, or maybe even 20 dollars of new loans depending on the reserve requirement. This is what is known as the “multiplier effect” and it is the reason why credit expansion or contraction carry so much weight when it comes to inflation.
Which brings us back to the question at hand…is inflation about to ramp up or has the move in bond yields been premature? As with all questions concerning the future, no one knows for sure, but we would venture to say that the latter is most likely the case. The economy is definitely improving but that doesn’t mean that it is healthy and sustainable. It is hard to quantify how much of the recovery over the past four years has been due to the normal cyclicality of the market and how much is attributed to massive monetary intervention. The fact that the very hint of slowing down (not stopping) the current QE program has been enough to send bond markets scurrying for cover and increased the volatility in the stock market is a sure sign of just how much power the FOMC has over the financial markets. As we’ve stated many times before, over short periods of time markets will be driven by shifts in sentiment but over long periods of time the fundamentals will eventually win out. We think the sell-off in defensive, high yielding assets is overdone and are taking this opportunity to increase exposure to these types of investments.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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