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The Bond Market Bubble and the Hint of Tapering

By: John D. Jones

In April, the 10-year Treasury was yielding around 1.65 percent, and now the yield is 2.95 percent. Bond portfolio profits have declined dramatically and many portfolios have experienced net losses. For the past five years or so, the profit or loss in the bond portfolio was not a significant topic of discussion for bank management, but now that losses have suddenly appeared, the discussions have begun. How did we get to this point?

We all knew in the back of our minds that at some point interest rates would rise and most opined, based on earlier Fed pronouncements, that the move would not begin until 2015 or later and it would be very gradual. Well, as we all know now, the rise in interest rates began much sooner, and the rise has been swift, not gradual. In the two months of May and June, the 10-year Treasury yield jumped 56 percent; the largest two-month move in a generation. To say the least, the timing and magnitude of the rise in interest rates has been a surprise.

The consensus is that yields began to rise in earnest on or around May 22 — also known as Bernanke Day. That was the day when Federal Reserve Chairman Ben Bernanke seemed to hint at tapering the Fed’s $85 billion-per-month bond-buying program. Bond market participants were caught off-guard, or leaning in the wrong direction, when near-term Fed tapering became more of a possibility. The direction some market participants were leaning was based on data-dependent policy decisions and anticipated continuation of quantitative easing. The data benchmarks triggering tapering had been previously announced as levels of inflation above 2 percent and unemployment of 6.5 percent or less.
As rates rose in the days following May 22, a record amount of money poured out of exchange-traded funds and mutual funds, according to a report by Trim Tabs Investment Research. The redemptions nearly doubled the amount pulled out of bond funds at the height of the financial crisis in 2008. Withdrawals from bond funds and exchange-traded bond funds totaled more than $30 billion through mid-August, reported as the third-highest monthly figure on record. The mass exodus from these funds contributed greatly to the decrease in bond prices and rising yields. Simply put, the market had many more sellers of bonds than buyers. Like an avalanche cascading downhill, bids for bonds fell significantly or evaporated as the inventories of bond dealers swelled faster than managements deemed prudent.

How did the bond market get so frothy and overpriced? Many say it was a combination of time and unusual moves by the Federal Reserve. Perhaps the bond market bubble began at the December 2008 FOMC meeting when the federal funds rate was cut to a target range between zero and 0.25 percent. With that, the federal funds rate has been effectively zero for almost five years. To spur economic growth, the Fed began an unconventional monetary policy of a series of quantitative easings in late 2008. The Fed implemented quantitative easing by buying specified amounts of financial assets from commercial banks and other private institutions, thus increasing the monetary base. The Federal Reserve held between $700 and $800 billion of Treasury notes on its balance sheet before the 2008 recession. After implementing QE1, QE2 and QE3, as of Aug. 21, the System Open Market Account managed by the Federal Reserve Bank of New York held more than $3.3 trillion of T-bills, notes/bonds, TIPS, federal agency securities and mortgaged-backed securities.

In May, few believed that quantitative easing was about to be tapered. The Fed had formally said in released statements that economic policy was data dependent. In policy statements it was noted that the fed funds target rate could remain low until 2015 and that as long as inflation remained within measures and unemployment remained above 6.5 percent, policy would remain unchanged. On May 22, the Fed hinted that tapering of quantitative easing might be a possibility. This hint of less bond buying by the central bank was interpreted as a signal of the end of low rates and therefore enough to pierce the bond market bubble.

Economic data is still not robust in terms of growth. By the time this article prints, the much-anticipated September FOMC meeting, expected by many to announce the beginning of tapering, will have occurred. How much more do we now know? Most likely not enough; we can only assume. Hmmm … much like we assumed before May 22. The next FOMC meeting is Oct. 29–30 so stay tuned.

John D. Jones is senior vice president, Capital Markets Group at Country Club Bank, Kansas City.

Copyright (c) October 2013 by BankNews Media