Like many Americans nowadays, I tend to tune out much of the mainstream media, but I did catch myself watching a little CNBC recently. Interestingly, it made me realize that the buy side, sell side, and media are arguing with many of the same platitudes on the topic of the Federal Reserve tapering its bond-buying stimulus. In short, no one has any real conviction or strong insight. Their views are not having any impact.
In the land of bonds, of course, PIMCO’S Bill Gross is widely considered to be the impact player. And rightfully so. PIMCO is the world’s largest bond investor and manages over $2 trillion in assets. Even if we don’t agree with PIMCO’s research or views (we often disagree), there can be no debate that the firm has the proven ability to impact asset prices in a meaningful reallocation.
So, what is the latest from the big bond boys on the taper? Well, this is what Gross wrote in his most recent monthly letter (which incidentally is usually a fun read … ):
“The taper will lead to the elimination of QE at some point in 2014, but the 25 basis point policy rate will continue until 6.5% unemployment and 2.0% inflation at a minimum have been achieved. If so, front-end Treasury, corporate and mortgage positions should provide low but attractively defensive returns.
We have positioned our bond wars portfolio — heavily front-end maturity loaded along with credit, volatility and curve steepening positions, with the aim of outperforming Vanguard as well as many other active managers.”
In part, especially given PIMCO’s sizable position, Gross’ job is to influence and ensure the bond market doesn’t shake, rattle, or roll in any direction that isn’t beneficial to PIMCO. So for example, if you are Gross, you certainly want the incremental buyer to be focused on mortgage-backed securities (MBS).
Currently, $40 billion of the Fed’s monthly purchases are in the MBS market. In aggregate, this is more than half a trillion in annual purchases of mortgage-backed securities. The impact of multiple rounds of QE has been that the premium of Agency MBS over Treasuries has narrowed by some ~50 basis points from pre-QE to post-QE.
Given that 34% of PIMCO’s Total Return Fund (BOND) is in agency MBS, there is some serious interest rate risk in that position. By our estimation, a 50-basis point move in the spread of Agency MBS has the potential to lead to 5% downside in price. To the extent that 34% of PIMCO’s “book” has the potential to be marked down 5%, that is a big deal for PIMCO and the associated market.
Reflexively, if PIMCO were to underperform, it would then be forced to liquidate MBS positions as investors exited their funds. In turn, this would amplify any move in price. A mass exit of PIMCO would be an “¡Ay, caramba!” moment in the MBS market to be sure.
On the longer end of the curve, specifically 10-year yields, tapering is getting somewhat priced in. In the chart below, we show this graphically by comparing 10-year yields, to the Fed Funds rate, to the Federal Reserve balance sheet. As you can see, 10-year yields are now back at a level not seen since early 2011, which pre-dated QE Infinity (i.e. the open ended purchases that began in September 2012).
In the hypothetical world where 10-year rates actually get priced based on economic fundamentals, the current spread of 2.6% between the 10-year yield and the Fed’s discount rate may not be far off reality. For context, the average spread between the two over the last decade was about 1.7% and since 1954 0.54%. Certainly, the 100 basis points widening of this spread over the last year is indicative of some level of tapering being priced in.
This all leads to an interesting question: Will tapering be a “sell the news” moment for 10-year yields? That’s a question I’ll leave to the speculators and those that need to protect their book to answer.
One point that many pundits don’t seem to be talking much about is that tapering will be positive for the U.S. Dollar, which has fallen five weeks in a row. This is further supported by a point we have been highlighting consistently — that the Federal deficit has been narrowing. In the fiscal year ending 2013, the federal deficit was below $1 trillion for the first time since 2008.
This improvement continued into this fiscal year as the deficit in November was 21.4% lower than the previous November. In addition to this budget improvement, the fact that Congress seems to actually be functioning should also bode well for the U.S. Dollar.
In fact, the House and Senate announced a two-year budget deal. Even if the deal isn’t ideal, our elected officials are (thankfully) at least getting out of the way and signaling to the world that they can functionally manage the country. From a deficit perspective, there will be $63 billion in increased spending (sequester relief) over the next two years, but that shouldn’t impact the continued narrowing of federal budgets. It’s amazing what our elected officials can accomplish when they get out of the way.
Just imagine what would happen if the unelected officials at the Fed got out of the way, the strong dollar American growth story would be fully in play!
Daryl Jones is Director of Research at
Hedgeye Risk Management
. You can follow him on Twitter