THE BLOG
06/21/2013 03:44 pm ET Updated Aug 21, 2013

Has the Fed Lost Control?

I had expected the Fed to 'grab the nettle', and this week's FOMC statement and Bernanke's comments at the subsequent press conference certainly did not disappoint.

The statement was quite significantly more hawkish, as they altered the reference to "downside risks" by indicating that this risk has diminished "since the fall." Furthermore, its rather dismissive reference to disinflation as "transitory" and its assertion that inflation expectations were "stable" displayed a pretty sanguine reaction to the recent falls in some measures of inflation expectations. The TIPS (US inflation-linked Treasuries) breakeven implied forecast for where 5-year inflation will be in 5 years' time has fallen about 70bp since March. Although admittedly this indicator stands in quite sharp contrast to both survey-based data, such as the University of Michigan Confidence Survey, and other indicators of economic health, such as the daily Rasmussen Consumer Confidence Index which continues to make new multi-year highs, that doesn't sound like a recipe for deflation.

I suspect that this attitude to inflation and lower forecasts for the crucially important unemployment rate were the points on which the rates markets chose to focus and their suspicion must now be that, if the Fed can lower its unemployment forecasts once, then why not again and by an even greater degree, bringing the stated 6.5 percent threshold for rate rises into view?

The Chairman was at pains to emphasize that, whilst the decision to taper QE may be imminent, 'if the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year', the decision to raise the Fed Funds rate has not come any closer, and this was backed up by the fact that the Summary of Economic Projections (SEP) showed that of the 19 FOMC participants, 14 expect the first hike to be in 2015 and 3 in 2014 (versus 13 and 4 in the March SEP), with still 1 each in 2013 and 2016. The median and average projections for the Fed Funds target at the end of 2015 were unchanged at 1.00 percent and 1.3 percent respectively.

However, despite his best efforts, the futures markets brought their predicted date for rate rises much closer, fully discounting the first 25bp hike by April 2015, and a much greater rise in rates thereafter.

Unsurprisingly, US Treasury yields spiked by 30bp in the 10-yrs, the USD strengthened, and stock markets suffered, as they nervously contemplated an amelioration in the supply of liquidity on which they have gorged themselves for the last 3 years.

Ten-year yields on conventional Treasuries have now climbed by 80bp since the beginning of May, but they are still only 2.4 percent.The range of this yield since the collapse of Lehman Brothers has been from 1.39 percent to 3.99 percent, so traders may well come to take the view that this yield has a lot of 'upside' left. Take into account the negative 'convexity' of the US Mortgage industry, which means that the more yields rise, the more Treasuries the huge mortgage suppliers have to sell, and one begins to realize this move may really have "legs."

There is now a probable pronounced asymmetry about bond traders' reaction to US economic data over the next two months, say. Any weak data points will be dismissed as outliers; aberrations, with any hint of a slowdown will be rapidly dismissed by the next scheduled release. After all, if the Fed is confident that the economy will grow strongly enough to reduce unemployment, who are we to question their judgement?

So, in this more 'normal' world, where the Fed stops printing money, why shouldn't yields return to more 'normal' levels like 4 percent, or at least 3.5 percent, say - hardly usurious rates of interest? A move of that magnitude, over the next 6 months or so, would certainly raise the prospect that the Fed had lost control of the bond market - much as it did in 1994.

Whilst I can see an overshoot in 10-year yields, which takes us to 3 percent this year, I think it's unlikely we would go much beyond that, due to four main factors:

1) Self-correcting mechanisms. A spike towards 4 percent would definitely cause a huge wobble in stock markets and other risk asset classes, with attendant scare stories of huge losses and institutional bankruptcies, which in term would scare traders back into bonds.

2) The Fed, although keen to avoid the inflation of bubbles, would be wary of the tightening in economic conditions implied by those kinds of rates, and the probable attendant distress in other markets, and would probably restart its printing presses - QE4!

3) Japan. The enormous amounts of money being printed by the BOJ will seep around the world and a large amount will end up in US Treasuries, especially if they start to yield over 3 percent.

4) The flow of Fed bond purchases may slow or end, but there is a huge outstanding stock of holdings sitting on the Fed's books, which will very probably never be sold back to the market.

What's the bottom line? Strap yourself in - it's going to be extremely volatile, and be wary of both equity and bond markets. Sitting on a pile of cash until 10-year Treasuries yield close to 3 percent may be a good plan.