Bernanke’s Maradona swerve hits bonds; how the Federal Reserve chairman has managed to tighten US financial conditions by more than 100 basis points without touching the Fed funds rate

September 16, 2013 8:43 am

Bernanke’s Maradona swerve hits bonds

By Steven Major

Clues to Fed chairman’s plan were in ‘term premium’ talk

Has Ben Bernanke delivered a modern version of the Maradona effect? It may help to explain how the Federal Reserve chairman has managed to tighten US financial conditions by more than 100 basis points without touching the Fed funds rate. The analogy, first applied to monetary policy by Sir Mervyn King, former Bank of England governor, refers to the ability of famed Argentine footballer Diego Maradona to clear a path to goal by wrongfooting opposing players as they tried to anticipate his next move. The bond market may not have been wrongfooted by Mr Bernanke’s swerve if it had paid better attention to what he said in March this year. We are used to thinking of his May 22 comments on the phasing out of US quantitative easing as this year’s key event for financial markets. It marked the start of the sell-off in US Treasuries, which contributed to big ructions in many emerging markets. But it was the earlier speech that provided some clues. Speaking about long-term interest rates on March 1, Mr Bernanke mentioned the phrase “term premium” no less than 28 times.The “term premium” has been the dominant driver of the US Treasuries market for the past 10 years, so it is crucial to understand what it is, and what its components are. There are essentially three elements to bond yields – economic growth expectations (as reflected through real short-term rates), inflation expectations and the “term premium”, which is all the other factors that collectively influence the yield.

It is easier to observe growth and inflation expectations by looking at things like trend growth and the yields on inflation-linked bonds, than it is to measure the term premium precisely. This is mainly because term premium is a “catch all” phrase for a number of different components that can enhance or offset each other. These mostly push yields down (and prices up) because they are sources of additional demand for bonds.

Mr Bernanke identified five contributors to the term premium – volatility, bond correlations with equities, haven flows, the recycling of current account surpluses and Fed asset purchases. They are not mutually exclusive – indeed they can overlap, not contribute at all or cancel each other out.

For example, haven demand at a time of heightened geopolitical risk would drive yields down, at a time when expectations of reduced Fed purchases are working in the opposite direction. When all factors are working in the same direction it is possible to explain how yields reached a low of 1.5 per cent in July 2012. The partial unwind is the main explanation for why they are already back to 3.0 per cent

Our research shows that over the past 10 years, a period characterised by low growth and benign inflation, corrections in the US Treasury market have mainly been driven by increases in the term premium, whereas between 1993 and 2003 rate expectations and/or inflation were driving the process.

Moreover, the term premium has been a huge influence on the Treasury market; it has amounted to as much as 200 basis points of the yield, no small amount when the overall yield has never been above 4 per cent in the past five years.

The recent rise in Treasury yields is most readily explained as a term premium move – already the second largest of the past 10 years and mainly an overreaction to expectations of lower Fed purchases. It is not the only driver, of course, because there has been a modest pricing-in of rate hikes starting next year.

Once there is greater clarity on the timing and scope of tapering – which could come as early as this week’s Fed meeting, the market will settle down. Indeed, tapering is now broadly priced in, and the volatility that has accompanied it will gradually subside.

That means yields are likely to fall back towards the lower end of their recent range. This is not a consensus view, which is close to the forward rate of around 3.3 per cent for 10-year Treasuries in one year’s time. We do not expect US growth to rise substantially nor inflation expectations to pick up. As for the “term premium”, we expect it to turn more negative again. That process may be assisted by some of the fiscal challenges facing the US – including discussions around the US budget and debt ceiling – as well as geopolitical risks that could prompt the return of haven flows.

Those shorting the Treasury market might soon resemble those trying to confront the formidable skills of one of football’s greatest. Mr Bernanke may have just sent them off in the wrong direction, enabling him clear sight of the goal: getting what he wants without actually doing anything.

Steven Major is global head of fixed income research at HSBC