In quantum mechanics, the Heisenberg Uncertainty Principle states that there is a limit to the precision with which the position and momentum of a particle can be known simultaneously. The Fed is discovering that by transitioning economic decision making from private actors to central bank interventions, it is trapped in its own uncertainty principle, unable to simultaneously estimate the true strength of the economy and the impact of quantitative easing. Furthermore, the longer it takes the economy to get to its final destination (5.5% unemployment) the more uncertain it becomes that this destination is justified as the non-accelerating inflation rate of unemployment (NAIRU) may have shifted significantly higher due to structural impediments, fiscal drag, growing skills gap of the long-term unemployed and recalibrated global economic growth expectations.
Given this backdrop, the last two months have witnessed regime shifts in the Fed, real yields and volatility. Specifically, the Fed shifted to a more neutral monetary policy stance in the June meeting when Bernanke laid out a roadmap for the tapering of asset purchases. This change in directive was likely brought about by concern over asset bubbles (championed by Jeremy Stein) and possible doubts regarding the transmission mechanism of equity and house price appreciation to greater employment. Quoting Bernanke, “if the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year. And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear.”
While Bernanke later tried to lessen the impact of his statement by reiterating that the Fed remains data dependent, markets were not reassured. Equities, high yield, emerging markets and commodities all have traded skittishly since the statement, and 10-year nominal Treasuries have sold off over 100 bps in the last two months!
The magnitude of the sell-off in nominal Treasuries presents three distinct new conundrums. One, the flow effect clearly matters in addition to the stock effect of the Fed’s balance sheet for market pricing. Two, there is no such thing as a “safe-haven asset” anymore, as when liquidity evaporates, Treasuries are not immune to selling pressures. Three, the impact of Fed manipulation on Treasury yields was demonstrated to be larger than many realized.
Most interesting, however, Treasury Inflation-Protected Securities (TIPS) real yields actually led nominal Treasury yields in the sell-off. Five-year real yields, which were at -1.79% at the beginning of April, at one point reached positive territory! Thus, the sell-off to higher yields coincided with a narrowing of TIPS implied breakeven rates. While a narrowing of breakeven rates would suggest stronger deflationary pressures, and the flattening of the 10-year/30-year nominal curve and commodity struggles reinforced this, there are many factors driving real yields apart from pure fundamentals. Given that TIPS are an illiquid asset class and the sell-off took place into quarter end with larger dealer balance sheet constraints, it may be incorrect to read too closely into the forecasting ability of breakeven rates. This was confirmed in the short term as real yields ended up retracing almost 30 bps from their highs.
5-YEAR REAL YIELDS LEAD SELL-OFF, COLLAPSING BREAKEVENS
Longer term, however, it appears unlikely that real yields will retrace back to their negative extremes. The reason for this lies in the distinct difference between the primary drivers of real yields. While nominal Treasury yields are more a function of direct Fed purchases, flight to safety bids, portfolio diversification and deflation protection, real yields got to the extreme negative levels they were at largely due to the market’s acceptance of a permanently aggressive Federal Reserve that was going to do whatever it took to shift people out of the portfolio balance channel. Going forward, however, the Fed has clearly shifted from a “whatever it takes” mantra to a “reversal is imminent” slogan. Regardless of whether this is due to quantitative easing’s success, impotence or auxiliary risks, it seems unlikely that the Fed will be able to shift back into a “whatever it takes” stance while maintaining credibility with a forward forecasting market.
If unlimited Quantitative Easing was Bernanke’s policy of successfully convincing the market that he is a madman, just like Henry Kissinger’s nuclear policy with Russia during the Nixon administration1, then laying out a roadmap to tapering actually pulls away the curtain and reveals the Fed as being sane and rational. While -2% real yields might be accepted under a “mad” Fed regime, a reasonable Fed will certainly not be able to push real yields to such extremes – particularly when a slowly recovering economy makes alternative investments more attractive than locking in negative real rates of return.
Given financial markets’ dislike of uncertainty, this change in directive by the Fed also comes at a precarious time for the Committee, as Bernanke’s term as Chairman ends in January and given President Obama’s recent remarks, he will not be returning. While Janet Yellen is favored to be appointed after Bernanke and keep Fed policy largely status quo, the departure of Bernanke will still result in the Committee losing a powerful dovish voter at a time when policy decisions and communications have become increasingly democratized.
As a result, we have likely seen the beginning of a regime shift towards higher rate volatility. There are three main factors that argue for increased rates volatility going forward. First, if the Fed has truly transitioned to a more neutral policy stance, then they will also transition from compressing rates volatility (through asset purchases, forward guidance and non-hedging of their negatively convex mortgage portfolio), to elevating implied volatility through reduced market intervention. Second, realized volatility is likely to remain heightened due to the previously mentioned uncertainty as to the true strength of the economy and the full impact of quantitative easing (which will soon be reversed). Another auxiliary factor increasing realized volatility is reduced risk taking capacity on the sellside due to lower VAR limits and balance sheet capacity, which was witnessed in the recent sell-off as dealers were not able to facilitate an orderly move to higher yields with Treasury bond holders all panicking at the same time. Finally, rates volatility will remain elevated the longer we are able to stay at higher yields, as the path of future yields now becomes more normally distributed.
1Y*10Y VOL RISING WITH RATES
Part of the reason why the Fed was able to successfully compress volatility with unlimited Quantitative Easing was that their reaction function switched from being data dependent (starting and stopping as needed) to being overwhelming. As the Fed’s reaction function reverts back to being data dependent, implied volatility will settle in a higher range.
In essence, the Fed is discovering that a communication policy of full disclosure is not consistent with a monetary policy goal of overwhelming the market into increased risk taking and employment growth. As such, the Fed remains in both a policy and communications trap. It cannot simultaneously buy Treasuries to stimulate the economy while also looking at Treasury yields as indications of economic strength and future inflation. It also cannot transparently talk of unwinding stimulus, when the market reaction to such talk removes the positive effect of the stimulus that was provided and hence makes unwinding it even more precarious. The Fed found out very quickly that while it can successfully elevate equities and housing prices, it is not able to control both the pace and direction with which the rates markets transitions from controlled distortions to free clearing levels.
The core premise of the Heisenberg uncertainty principle is that in attempting to observe a particle you alter its behavior. One way to view Bernanke’s taper talk is as a litmus test of the strength of the economy. Yet, the higher yields that were brought due to his words will certainly negatively affect growth to some degree as higher funding rates will directly impair the housing recovery and the ability of corporations to fund expansionary projects at cheap levels. As Bernanke attempts to observe where the economic recovery is, he inherently changes it!
In conclusion, due to the Bernanke uncertainty principle the Fed is no longer able to accurately gauge the strength of the real economy and the impact of its stimulus (or negative impact of its removal). By laying out a roadmap for eventual tapering, Bernanke realizes as much, embarking on what was perceived as a regime shift for the Fed. The Fed is no longer crazily doing “whatever it takes” but rather is sanely “looking to stop.” This changes the market’s perception of their reaction function and reduces confidence in the Fed’s ability to push real yields negative and contain rates volatility.
1 From Dario Perkins’ “Bernanke turns ‘madman’”, Lombard Street Research, September 26, 2012.
Any issuers or securities noted in this document are provided as illustrations or examples only, for the limited purpose of analyzing general market or economic conditions, and may not form the basis for an investment decision. TCW makes no representation as to whether any security (or the security of any issuer) mentioned in this document is now or ever was held in any TCW portfolio. TCW is not recommending the purchase, sale or holding of any security and is making no representation or indication of its own holdings of any securities. TCW may in fact be currently recommending the purchase of a security or the sale of a security regardless of any statement made in this document about that security or whether TCW owns it or not. Discussion of securities in this document are strictly for educational use only and are not intended to serve as investment advice. Any statement made in this document, including any statement or implication drawn from any discussion of individual securities, is subject to change at any time, without notice.
This publication is for general information purposes only. Past performance is no guarantee of future results. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision.
Any opinions expressed are current only as of the time made and are subject to change without notice. TCW assumes no duty to update any such statements. The views expressed herein are solely those of the author and do not represent the views of TCW as a firm or of any other portfolio manager or employee of TCW. Any holdings of a particular company or security discussed herein are under periodic review by the author and are subject to change at any time, without notice. In addition, TCW manages a number of separate strategies and portfolio managers in those strategies may have differing views or analysis with respect to a particular company, security or the economy than the views expressed herein.
MetWest is a wholly-owned subsidiary of The TCW Group, Inc.
This piece is cross-posted from TCW with permission.