End of QE will drive a bond sell-off to remember; Debt losses will accelerate as equity markets gradually accept Fed taper

August 9, 2013 11:52 am

End of QE will drive a bond sell-off to remember

By Michael Mackenzie in New York

Debt losses will accelerate as equity markets gradually accept Fed taper

Bond investors hurt by this summer’s interest rate turmoil may be surprised to find the damage was small by previous standards. The rapid rise in bond yields from May fails to crack the top 10 list of fixed income routs for the past 50 years, according to Liberty Street Economics, a website that publishes research from economists at the Federal Reserve Bank of New York.* Of the 15 largest bond market debacles since 1961, this year’s interest rate shock ranks at number 13, based on the economists’ criteria for defining such events. Before fixed income investors take umbrage at such a lowly ranking for the hefty losses they have just experienced, Liberty Street has not yet called time on this year’s stampede out of bonds. Just like a sleeper song or film, the bond market’s current affliction could climb further up the hit parade, with September delivering another employment report and a Fed policy meeting that could well launch a reduction, or taper in the central bank’s $85bn of monthly bond buying.While long-dated Treasury prices stabilised this week, thanks in part to reasonable demand for the auction of new 10- and 30-year paper, benchmark yields remain near their recent peaks, hardly a reassuring sign for the future.

Also, on closer inspection, the speed of the recent rise in yields compares closely with the big routs of 2003 and 1994.

Liberty Street calculates that Treasury losses peaked with a cumulative return of -11.3 per cent in July, just shy of the August 2003 nadir of -13.8 per cent, and the -17.5 per cent seen in November 1994.

What uniquely characterises this summer’s turmoil is how investors have demanded a greater premium for owning long-dated Treasuries. Unlike 2003 and 1994, the selling pressure has not resulted from the expectation or implementation of rate rises from the Fed that in turn weighed heavily on shorter Treasury maturities such as the two-year note.

Liberty Street’s analysis explains that all the recent increases in yields can be explained by the rising term premium. This is in sharp contrast to prior bond market sell offs, “when yield movements were nearly entirely due to changes in the future path of policy”, says Liberty Street.

Of course this is a very different bond market from a decade ago, reflecting the huge role of Fed bond purchases under quantitative easing. With overnight rates stuck near zero since December 2008, and the aim of QE being the suppression of long-term interest rates, it stands to reason that a market reversal will take on a different hue compared with past episodes.

Notably, inflation bonds and real yields, not nominal or cash Treasuries, led the bond rout this time and losses for investors. Suppressing real yields was the main objective of unlimited QE. Indeed it worked so well that as recently as April, the 10-year real yield was negative 0.70 per cent. By July that yield was plus 0.63, a turnround of more than 1.3 percentage points, handily outstripping the rise in nominal 10-year Treasury yields.

Profound changes across US fixed income markets since the previous two big bear markets of 2003 and 1994 argue that more interest rate pain beckons for investors, once the Fed Taper starts in earnest and attention naturally focuses on the start date for rate hikes.

Outstanding US corporate debt has more than doubled to more than $9tn since 2003 and in recent years investors have pumped a record $1tn plus into bond funds at all-time low yields. Against the spectre of investors dumping bonds, Wall Street dealers have dramatically reduced their support for trading bonds under the duress of tougher capital standards and risk management standards.

Vast exposure on the part of bond investors and a small exit has exacerbated this year’s bond sell-off and points to a potentially epic bear run for fixed income.

The risk remains that fixed income investors will accelerate their flight from bond funds in the coming months as their performance badly lags behind equities, propelling long-term yields to fresh peaks.

That’s the good news for investors. Should the Fed’s taper segue towards a normalisation of overnight rates, watch the bond rout surge into the top 10 list with a bullet.