Remember the Fed insisting that “tapering isn’t tightening?”
The first time the Fed tried to signal the beginning of the tapering during the summer of 2013, the bond market backed up dramatically. The rise in yields was so large that monetary conditions tightened to the point where the Fed panicked. They surprised the market by reversing a clearly indicated tapering signal.
The September 18th, 2013 Federal Reserve meeting shocked market participants with the following statement:
“The Committee sees the downside risks to the outlook for the economy and the labour market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and the labour market.”
Here is the chart of the September 2016 Eurodollar contract. I have chosen this contract because it seems to be the battle ground for the beginning of any real moves higher in the short term interest rates:
Sep 2016 ED Contract (higher is lower rate)</a>
After their initial taper debacle the Fed was more careful. As the Fed approached the next attempt to taper, they were careful to emphasize that “tapering is not tightening.” That message was continually driven home in speech after speech by the Federal Reserve Chairman.
Therefore as the taper was instituted, the bond market priced in a tightening at the end of the tapering, but the damage was quite limited.
Sep 2016 ED Contract</a>
The Fed managed to start the taper without the bond market revolting.
The message that just because the Federal Reserve was tapering did not mean that rates were necessarily going higher anytime soon was finally sinking in. As the taper progressed, the bond market became increasingly comfortable.
The best way to illustrate this is to have a look at the Fed Funds projected rate as implied by the futures contracts:
Fed Funds contract curve</a>
This curve shows the implied future Fed Funds rate at various points in the past. The red curve is the implied Fed Funds curve the day before the surprise no taper announcement (September 17th, 2013). The blue curve is a month ago, the green curve a week ago and the orange curve is yesterday.
What this demonstrates is that there has been a steady move lower in the implied future Fed Funds rate. The “tapering is not tightening” mantra is finally been accepted by the marketplace.
Which brings us to the interesting part of this discussion. Why the shift in attitude by market participants?
You can’t really make the argument that the economic data has gotten significantly weaker. In fact, if anything it is firming up. Inflation is running hotter than forecast and the employment figures were quite strong. The economic surprise index which measures how much the economic releases are outperforming or under performing expectations has in fact being steadily climbing higher over the last couple of months:
Economic Surprise Index</a>
I believe that the answer as to why the bond market has rallied so hard all comes down to the work of retired Fed Chairman Ben Bernanke.
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Since stepping down as the head of the Federal Reserve, Ben Bernanke has been travelling around the globe, giving a series of speeches and special one on one meetings at $250k a pop. Although his message does not seem to be that different from the position he took as the Federal Reserve Chairman, his frankness in describing the amount of accommodative easing that will be required in the future has caused a sudden realization amongst the big connected players that “tapering is **truly not** tightening.”
Before Ben’s magical private roadshow, many market participants were skeptical that the Fed was going to keep rates at zero after the tapering finished. Although they heard the message from Yellen and the other doves that “tapering was not tightening”, they also saw the projections from the hawks on the Federal Reserve board that had rates rising to more normal rates within the next couple of years. Given the abnormally low rates, absence assurances from the Federal Reserve that rates were going to stay at stupid low levels, it made sense to unwind carry trades.
However, Bernanke’s meetings has changed their attitude:
> Hedge fund attendees have included Paul Tudor Jones of Tudor Investment Corp and David Einhorn of Greenlight Capital. Others have included Michael Novogratz of Fortress Investment Group, and Larry Robbins of Glenview Capital, as previously reported in other media. All declined to comment to Reuters.
> David Tepper, the hedge fund manager who earned $3.5 billion in 2013 to rank as the industry’s best paid investor, said at an industry conference this week that he attended the first private dinner and peppered Bernanke with questions. But Tepper said he didn’t make the best use of the information, a lapse he now regrets. “I screwed up that trade,” he said.
> At the same conference, Novogratz from Fortress said many hedge funds that bet on big interest rate and currency movements missed a hint from Bernanke at the dinner and failed to buy long duration Treasuries.
Bernanke’s admission about the dire state of affairs has resulted in many market participants re-thinking their position:
> “At least one guest left a New York restaurant with the impression Bernanke, 60, does not expect the federal funds rate, the Fed’s main benchmark interest rate, to rise back to its long-term average of around 4 percent in Bernanke’s lifetime. ”Shocking when he said this,“ the guest scribbled in his notes. ”Is that really true?“ he scribbled at another point, according to the notes reviewed by Reuters.”
This move in the bond market has largely being the result of large market players covering their bearish bets of tapering ushering in a tightening cycle. Bernanke’s frankness during one on one meetings has finally convinced them of something that the Fed has been trying to convince them of for the last year.
Bernanke has caused one of the greatest short covering squeezes in quite some time. I have no doubt that he believes that rates will be lower for longer than ever before. I have long argued that the Federal Reserve is going to be behind the curve the whole way up. The Federal Reserve is not going to lead the move higher in rates, and in fact, will fight it the whole way higher. They will only raise rates reluctantly as it becomes obvious that inflation has gotten out of control.
However I believe that traders that are buying the long end of the curve because of the retired Chairman’s belief that rates will be low for quite some time are playing with fire. I have no qualms with the move at the front end of the curve. But at some point, this crazy loose policy is going to backfire on the Federal Reserve. Eventually they will lose control of the long end. Playing musical chairs by buying long duration bonds is a mugs game that I will leave to the hedge funds. After all, it’s not like they ever think they are all out smarting each other and crowd into the same trade together with disastrous results.