Recent movements in the Treasurys market are again suggesting that the post-crash era of ultra-low borrowing rates may be running its course. Don’t be fooled.
Sure, long-dated Treasury ETFs such as the iShares Barclays 20+ Year Treasury Bond Fund (TLT) and the Pimco 25+ Year Zero Coupon U.S. Treasury ETF (ZROZ) have lost 2.58 percent and 4.55 percent in the past month, respectively, but let’s keep those moves in perspective.
Firstly, even though yields on 10-year Treasurys have threatened to cross 2 percent in recent days, they’ve already been above 2 percent early this year. Moreover, they remain well within a range in the past year and pretty far below their post-crash highs.
With this perspective, it’s hard to see why the Federal Reserve and its Chairman Ben Bernanke would now front-load plans to unravel their five-year-old program of quantitative easing.
Yes, the economy is healing, but signs of lasting vitality—including an increase in bank lending, industrial capacity constraints, and pickups in the velocity of money and income growth—have yet to truly and consistently materialize.
That said, advisors and investors need to take seriously the front-page story last week in the Wall Street Journal detailing what the Fed is thinking about doing when it comes time to end this era of unprecedented accommodation. The Journal’s Fed reporter, Jon Hilsenrath, might be the most important journalist in the world right now, so we should all be reading him religiously.
It’s not what Hilsenrath said, but the simple fact that he said it, and how he said it—on the front page of the most important U.S. financial newspaper. Basically, the Fed is signaling that it wants us to know it’s thinking hard about what to do and when it needs to do it, as it well should be.
So, set that story aside and others from Hilsenrath that are sure to follow and use them as cheat-sheets so you’re familiar with how the Bernanke Fed may choose to work its work its way out of the most massive experiment of monetary easing in the history of capitalism.
In a less-nuanced frame of reference, it’s impossible to get away from the fact that Bernanke has said the extraordinary period of monetary accommodation is likely to remain in place at least until the unemployment rate falls to 6.5 percent. It is trending slowly downward, but remains at 7.5 percent. On that basis alone, the probability of rates truly heading higher right now seems about nil.
Then there’s the problem of the U.S. Congress and the unresolved fiscal outlook that hangs over the U.S. economy like a Sword of Damocles.
Bernanke has been pretty plain that his hand is being forced by Congress’ inability to jump-start a meaningful process that puts the world’s biggest economy on a path of budgetary sobriety. Translation:Expect a continued heavy hand from the Fed until all the Washington, D.C. dithering stops, meaning Democrats will make peace with more disciplined social spending and Republicans will be able to accept the possibility of higher taxes.
The market desperately craves some sign that the grownups are in charge of the economy and, like it or not, Bernanke is the best semblance of a grownup we’ve got right now.
Finally, it would behoove anyone who is reading the tea leaves on the interest-rate outlook to take a closer look at the mortgage-backed securities (MBSs) market, a part of the bond world that figures highly in all the Fed’s bond buying of the past few years.
MBSs make up about 30 percent of the Barclays Aggregate Bond Index compared with almost 38 percent for the U.S. Treasury market. So, sure, Treasury yields are crucial, and looking at TLT and ZROZ and the plethora of Treasurys ETFs across the yield curve makes sense.
But so too does looking at big, liquid MBS ETFs, such as the iShares Barclays MBS Bond Fund (MBB). The price of MBB has certainly been much more stable than TLT’s in the past few years, but that’s not really a sensible or fair-minded observation.
Yes, the Fed’s actions in the MBSs market have made mortgage rates less tethered to benchmark Treasury yields. But, the effective duration of MBB is now 3.35, compared with 16.84 for TLT, meaning MBB’s price will move less than TLT’s as rate expectations shift.
But if the duration of MBB, which iShares updates every day, starts trending higher, that would be a pretty clear indication that the refinancing juggernaut of the past few years may be running its course, and might even be stopping. No one refinances when rates are heading higher.
And, while I'm carting out this metric, it's worth noting that MBB's duration has been gingerly trending higher, perhaps quite like the unemployment rate has been trending down. It was 1.87 on May 29 of last year; ended 2012 at 2.15 and stood at 3.18 at the end of the first quarter. Right now, again, it's at 3.35.
It’s a coarse measure, to be sure, but if these incipient signs of a trend ripen into something more, I’ll dust off that front-page story Hilsenrath wrote last weekend; put on my seat belt; and hope to God that Dr. Bernanke’s plan works out.
At the time this article was written, the author held no positions in the securities mentioned. Contact Olly Ludwig at firstname.lastname@example.org.
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