Sep

12

There are several things that bonds don't take account of I think. The threat is worse than the execution. If the Fed tapers, it's already in the market and the amount of their reduction will be offset by reduced sales because of increased revenues. The stock of bonds is about 20 trillion As Tyler Cowen said, the stock of bonds, what existing holders will accept, is more important than the flow of 25 billion. The rate of inflation determines the yield. The rate past and expected is close to 1.5% and the premium that bond yields pay to the holders based on the Fed model is at an all time high. The ratio of stock market levels to bond levels is at a 3 year high and this is not bullish for stocks and bullish for bonds. The 10 year yield has pierced the barrier of 3% and frustration has been relieved. The levels of yields at 3% for the 10 and 4% for the 30 year are competitive with stocks and would cause a decline in the economy if they increased. I don't have a position in bonds but trade them fairly actively within the week. 

Rocky Humbert writes: 

FWIW, I agree 100% with everything that the chair wrote here — with a couple of additions:

1. The primary challenge that the market faces here is assessing the equilibrium yield in the absence of fed interventions. There will always be fed interventions at the front end, but the back end interventions are a recent (3 year) phenomenon and many purchasers (and now sellers) were engaged in front-running of the fed type activities. This is a flow-oriented phenomenon, not a value-oriented phenomenon. My general rule (and the Chair would surely agree) is in the short-term, flow trumps fundamentals for longer than the average leveraged speculator can tolerate. So, the primary question, I believe, is whether the front-runners have exited the market. My guess is that on the announcement of the taper, that process will be complete.

2. On a longer-term basis, the question of what real yield is "right" remains in front of us. The other Tyler has written eloquently (but I disagree) that TIPS should command a near zero real yield. I believe that TIPS should command a real yield that approximates the real growth rate of the economy plus some sovereign risk premium plus some liquidity risk premium plus some tax rate premium plus some risk premium associated with gaming the CPI which the government is motivated to do.

I have a speculative long (trading not investment) position in bonds (especially muni's and tips) right now, but that could change quickly and I don't recommend that anyone follows me into this, as we are suffering from a hindsight/anchoring bias where things look inexpensive because they were expensive before NOT things look inexpensive because they are really inexpensive. I think the odds substantially favor a rally versus an immediate further decline , but I base this on unqualifiable drivel which is not worthy of this list. In contrast, my Apple call was based on an extremely rare confluence that was in fact quantifiable and yesterday's decline in Apple (which I didn't participate in) was likewise statistically probable.

Jeff Rollert adds: 

I agree with both Chair and Rocky.

As long as the Fed can use open mouth policy and have traders do the heavy lifting, they will IMHO. Rolloff re-fills their quiver that way over time.

As I've mentioned on the list for a few years, an analytical shift has begun. As we never step into the same river twice, the next cycle begins with the consideration of what is the risk free rate when sovereign bonds are manipulated.

I have some unfinished ideas on this, but the core is a replacement of T-Bills. An alternative path is the question of can there be a risk free rate.

As modern monetary systems appear to share the characteristics of religious belief systems, I believe this is a material change.


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