Economic News & Analysis—July 18, 2013

Welcome to the Bernanke roller coaster

By James Kochan, Chief Fixed-Income Strategist

It is vacation season, a time when families visit the amusement parks to enjoy the rides. In that spirit, Fed Chairman Bernanke has put the bond markets on a roller coaster these past several weeks, with his (and his colleagues’) attempts to explain how the bond purchase program might be wound down. The roller coaster began its run following the May 1 Federal Open Market Committee (FOMC) meeting, and it gathered more momentum after the press statement and the press briefing following the FOMC meeting on June 19. That afternoon, the chairman tried to explain that, if the economy were to perform in line with the Fed’s expectations, monthly purchases of Treasuries and mortgage-backed securities would probably be reduced gradually, starting later this year, with the goal of ending the purchase program by mid-2014.

The bond market reacted as if the chairman was about to pull the plug on its liquidity bath. Prices dropped sharply, yields rose sharply, and the roller coaster ride was in full throttle. The yield on the benchmark 10-year Treasury note rose from 1.60% on May 1 to a high of 2.75% on July 5. Yields in the other sectors of the bond market rose apace. Some markets, such as municipals and Treasury Inflation-Protected Securities (TIPS), experienced severe price erosion. The Bernanke roller coaster took prices on a steep drop.

It soon became apparent that Fed officials were surprised and disturbed by the market’s reaction. The chairman and his colleagues took to the speaking circuits to explain that a gradual tapering in Fed purchases did not mean an end to monetary accommodation. But the more they tried, the more they seemed to confuse the markets. Market yields and mortgage rates remained elevated.

In recent days, their efforts have had a degree of success, aided by a few weaker-than-expected economic indicators. Bargain hunting by investors also helped pull bond yields slightly lower. Today, in his report to Congress, the chairman more explicitly stated that the future of bond purchases is “by no means on a preset course.” It might not be scaled down if economic data is disappointing or if “financial conditions were judged to be insufficiently accommodative…” In plain English: He is worried that the higher bond yields and, especially, the higher mortgage rates, might be hurting the economy. If so, the purchase programs could remain in place longer than had been anticipated.

Bond prices have recovered somewhat in response to those recent pronouncements. The yield on the 10-year Treasury is now below 2.50%, and yields in the corporate and municipal markets have declined 10 to 20 basis points from their highs. But they are still almost a full percentage point above the April–May lows.

This phase of the roller coaster ride suggests the potential for a new range for bond yields

Will this new phase of the roller coaster ride take yields back to the levels seen in late April? Probably not, in my view. The severity of the May through July sell-off suggests that a substantial volume of highly leveraged positions had to be liquidated once prices started to drop, and those positions are not likely to be reestablished. Those speculative positions might have driven yields to unsustainably low levels, especially in riskier markets such as high yield. The losses created as those yields moved back to more realistic levels will likely discourage the rebuilding of leveraged speculative long positions. Indeed, rallies might now elicit speculative selling rather than buying.

The Bernanke roller coaster has likely established a new range for the yield on the benchmark 10-year Treasury note centered around 2½%. Movements within that range will probably be in response to the economic indicators released in the weeks ahead. The housing and employment indicators will probably be the most influential. If the home sales data next week and the July employment report on August 2 are reasonably healthy, the markets might assume that Fed tapering will begin after the September 17–18 FOMC meeting, and bond yields could move back to early July levels. Weaker-than-expected data could send yields somewhat lower than today’s levels.

We recommend that investors ignore the short-term volatility and focus on the better values the Bernanke roller coaster has fostered. In my view, the two areas with the best long-term investment opportunities are now municipals and corporate high yield. After yield increases of a percentage point or more, they again offer the potential for better income and total returns over the next 12 months than alternatives such as Treasuries, mortgages, or TIPS.

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